What is Stock Market Index/ Indices? Nifty & Sensex

What would you do if I asked you to tell me the latest traffic situation in your city?

There will be thousands of roads and crossroads in your city, will you find out and then answer? It would be wise to find out the condition of some main roads and intersections so that you can tell the condition of traffic in every direction of the city. If these roads are crowded then you will say that there is a lot of traffic in the city and otherwise you will say that the traffic is normal.

Similarly, if you were asked about the stock market, what would you do? There are about 5000 companies listed on the Bombay Stock Exchange (BSE) and about 2000 in the National Stock Exchange (NSE), keeping track of whether their shares are going up or down will be a difficult task in itself.

Instead, the easiest way would be to find out the condition of the shares of certain types of industries or companies associated with the industry. If the shares of most of these companies are down then the market is said to be down and if the shares of most of the companies are up then the market will be said to be up. If some are down and some are up, then the market can be said to be mixed.

In this way, some companies can be made representative of the market and by looking at their condition, the condition of the market can be told. The group of these companies makes up the stock market index.

The Index – Nifty & Sensex

Fortunately, it is not necessary to look at each and every company in these selected group of companies separately to tell the market condition. All these companies have already been merged together and this merged group is continuously monitored and based on them the market condition is told. This group of companies is called a market index.

There are two main market indices in India – S&P BSE Sensex which is an index of Bombay Stock Exchange and CNX Nifty which is an index of NSE i.e. National Stock Exchange.

S&P (Standard and Poor’s) is an international credit rating agency. S&P is the specialist agency for making indexes and they are licensed to BSE. That’s why the name of S&P is added to this index.

The CNX Nifty consists of the largest and most traded shares of the National Stock Exchange. The responsibility of running this index rests with India Index Services and Products Limited (IISL). This is a joint venture between NSE and CRISIL. CNX here stands for CRISIL and NSE.

A good index tells us every minute how the market players are viewing the future of the market. The movement of the index tells us where the market sentiments are headed. When market people believe that the future is good then the index goes up and when these people believe that the future is bad then the index goes down.

Practical Uses of Index

Below are some specific uses of indexes.

Information– Index tells the direction of the market at a particular point of time. The economy of the country is also estimated on the basis of the index. A rising index suggests that people are expecting a better future. When the stock market index is down, it can be assumed that people are not excited about the future.

For example, Nifty was at 6301 on 1st January 2014 and 7580 on 24th June 2014. This means an increase of 1278 points i.e. a change of 20.3%. This means that the market went up strongly during this period, which shows that people were optimistic about the future.

The index can be used for any time frame. For example, on June 25, 2014 at 9:30 am the index was at 7583 but an hour later it reached 7565, this 18 points fall in one hour shows that the people in the market were not enthusiastic.

Benchmarking – Whether you are trading or investing, how do you measure its performance? Suppose you invested Rs.100,000 and earned Rs.20,000, now you have an amount of Rs.120,000. It’s great to hear that you got a return of 20%. But during this time Nifty came from 6000 to 7800 i.e. it gave a return of 30%.

Now you will feel that your return is less than the market. If you can’t do this comparison then you don’t know how your performance was. That is why performance is measured using the index as a benchmark. Everyone involved in the market tries to outperform the index.

Trading – Index is most commonly used for trading. Most of the traders in the market trade in the index. They predict the future of the economy or the market and make deals based on that.

For example, suppose the Finance Minister is going to deliver the budget speech at 10:30 in the morning. An hour before this, Nifty is at 6600. Do you think there will be some announcement in the budget that the country’s economy will improve? Where will the index go if this happens? Up isn’t it? Then you as a trader would buy the index at 6600.

Now the budget speech lives as you expected and nifty reaches 6900. Now you can exit the deal with your profit above 300 points. Such trades are done in the derivative segment of the market. All you need to know about derivatives now is that indices can be traded here, we will know in detail later.

Portfolio Hedging – Investors usually build a portfolio of stocks. In which there are shares of 10-12 companies, which have been bought for a long time. But sometimes such situations arise in the market (like in the year 2008) when there is a possibility of the market going bad for a long time. In such a situation, hedging has to be done to protect the capital of the portfolio from decreasing. We will discuss this in detail further.

Index construction methodology

It is important to know how an index is formed and calculated, especially for index traders. As we have learned that the index is made up of many stocks from many sectors and it represents the entire economy. In order to be included in the index, certain characteristics are observed in the stock and as long as those characteristics are present in it, the stock remains in the index. But if even one of those characteristics falls short then another stock with those characteristics takes its place in the index.

To create an index, a list of such stocks is prepared that fulfills all the conditions of those characteristics. After this, a weightage is fixed for each stock. Weight means the importance of that stock in comparison to other stocks in the index. As the weight of ITC in Nifty is 7.6%, this means that ITC plays a role of 7.6% in the rise or fall of Nifty.

Now the question is, how is the weight in the index decided?

There are many ways to do this, but the method used by the Indian market i.e. exchanges is called Free Float Market Capitalization. The weighting of stocks is determined by their free-float market capitalization, the larger the market capitalization, the higher the weight in the index.

To calculate the free-float market capitalization, the number of shares of that company in the stock market is multiplied by its price. For example, if 100 shares of a company are in the market and the price of that share is Rs 50 then the free-float market capitalization of that share will be 100 x 50 = 5000.

You can see that ITC has the highest weightage. This means that Nifty is affected the most by the change in the share price of ITC and the least by the change in the price of DLF.

Sector-specific index

Just like Sensex and Nifty tell the direction of the entire market, similarly, there are also indexes that tell the condition of different industries, which are called sector indices. Like Bank Nifty is a sector index that tells the condition of the banking industry. Similarly, CNX IT tracks the stock of the IT industry on the National Stock Exchange. There are sector indices on both BSE and NSE and they work like Nifty and Sensex.

Highlights of this chapter

1. Market indices tell the condition of the entire economy.
2. An index going up means that people in the market are optimistic about the future.
3. A fall in the index means that the market people are disappointed about the future.
4. The two main indices in India are BSE Sensex and NSE Nifty.
5. Indexes are also used for information, benchmarks, trading, and hedging.
6. The most common use of indices is for trading.
7. In India, the index is constructed using the free-float market capitalization method.
   Sector indexes are there to tell the condition of different sectors.