Stock indices are financial markets made up of individual underlying stocks. While the stock indices are independent markets to themselves, the values are calculated based on the price of the individual stocks in the index. Examples of stock indices include, NASDAQ 100, S&P500, Nikkei, FTSE100, CAC40, IBEX and so on.
Types of Stock Index Calculations
Stock indices are usually calculated in two ways. Direct Index calculation and Indirect Index Calculation.
A direct index calculation method, also known as a price-weighted index is based upon adding the individual stock prices. So if a stock index is made up of 5 individual stocks, then the direct index is made up by adding up the prices of the individual stocks. For example, DJIA.
An indirect index calculation or market value wighted index works differently, where in the prices of the individual stocks in the index are averaged and multiplied by the individual trading turnover and added together. So if a stock index is made up of 5 individual stocks, the price is aggregated and divided by 5 (the number of stocks in the index). This number is then multiplied 5 times with the respective trading turnover of each of the stocks and the result is summed up. Examples include Hang Seng Index.
The difference between direct and indirect stock index calculations is that in the former, every stock is valued in importance equally as compared to the latter, where the value of each stock is weighted individually.
To illustrate this difference, if in a stock index, the trading turnover of a particular stock is twice that of another stock, then the stock that has twice the trading turnover will have two times the impact than the other stock whose trading turnover is just half.
Understanding Stock Market Price Movements
An essential factor when trading the stock markets is the price movement. On a broad scale, market prices show movement due to the buying and selling. While this might seem easy to comprehend, market price movement is determined by “Buying and Selling Volume” and the “Bid and Ask Volume”
Buying and Selling Volume
The buying and selling volume is one of the factors that determins the price movements. Simply put, a higher volume of buying trades, pushes the stock price higher while an increase in selling volume triggers a fall in the stock’s price.
Bid and Ask Volume
The Bid and Ask Volume forms another factor that influences the stock’s price. Every stock that is transacted (i.e: bought or sold) requires two parties. The buyer and the seller. This basically sets up the buying volume and the selling volume. Every transaction, whether it is a buying trade of a selling trade needs to be entered into an order book. The order book consists of the bid price (which is the price for selling a stock) and the ask price (which is the price for buying a stock) and the last price (which is the prevailing market price and is the last traded price). The ask price is always higher than the bid price and the ask price always comes with a limit order to sell.
The ask price represents the lowest priced sell order that is available, whereas the bid price is the highest priced buy order which is available for the markets.
When an investor places a market order to buy, the trade is transacted at the prevailing ASK price. This influences on the last price, wherein the ask price becomes the ‘last price’ as the order has been fulfilled. At this point, the last price increases. At this sate, the last price can only remain at the ask price or can move upwards. This is known as a buying trade or buying volume.
In the same method, when a market order to sell is placed, the transaction occurs at the bid price or the selling price. This matches the sell order to the highest available buy order, thus changing the last price to the bid price which becomes the last traded price. At this point the last traded price can either remain stable or move downwards and thus forms the selling trade or the selling volume.
Understanding how a stock index is calculated and how the underlying stocks are weighted can greatly benefit traders who wish to trade in the stock markets either directly or via CFD’s through an online CFD broker that offer assets such as stocks and indices. Analyzing the stock market calculation helps traders to identify and potentially forecast the price movements by taking into consideration the underlying stocks, and their importance in the index.