What is a Stock Market Index?
Stock-Markets / Stock Markets 2015 Apr 24, 2015 - 11:59 AM GMTBy: Boris_Dzhingarov
For many people – entering the stock market and truly understanding the investment options available can be confusing. Today we will speak about stock market indexes and why these are important and how they work.
The most simple explanation is this: an index is literally made up of several stock prices into a single number. An Index can be made up based on markets or industries – and as the Options Industry Council (OIC) says, “Some are broad-based and measure moves in broad, diverse markets. Others are narrow-based and measure more specific industry sectors of the marketplace.”
The OIC also councils that is not always the number of stocks that comprise “…the average that determine if an index is broad-based or narrow-based, but rather the diversity of the underlying securities and their market coverage.”
There are a few types of Indexes ranging from Capitalization-Weighted which is term applying to that the stock prices making up the index is weighted toward larger companies. The OIC will help with the math here” “In calculating the index value, the market price of each component security is multiplied by the number of shares outstanding.”
Another type of index is called the Equal Dollar Weighted which is comprised of an equal number of shares from each stock. The OIC says that the Equal Dollar …” is calculated by establishing an aggregate market value for every component security of the index and then determining the number of shares of each security by dividing this aggregate market value by the current market price of the security.”
The OIC notes there are many types of indexes that can be pulled based only one industry to more broad-based companies. That said, there is flexibility. In today’s world of mergers and acquisitions the OIC reports that securities can be dropped if necessary.
“After the recent recovery from the stock market meltdown, index products provide many investors with diversified exposure and reduced risk from a concentration in one particular security,” explains Oleg Rud, President of Imperial Advance, a financial services firm in New York that offers working capital and business loans to small and mid-size businesses.
Other Types
An index can also be a simple average: calculated by simply adding up the prices of the securities in the index and dividing by the number of securities, disregarding numbers of shares outstanding. Another type measures daily percentage movements of prices by averaging the percentage price changes of all securities included in the index.
Adjustments & Accuracy
Securities may be dropped from an index because of events such as mergers and liquidations or because a particular security is no longer thought to be representative of the types of stocks constituting the index. Securities may also be added to an index from time to time. Adjustments to indexes might be made because of such substitutions or due to the issuance of new stock by a component security. Such adjustments and other similar changes are within the discretion of the publisher of the index and will not ordinarily cause any adjustment in the terms of outstanding index options. However, an adjustment panel has authority to make adjustments if the publisher of the underlying index makes a change in the index's composition or method of calculation that, in the panel's determination, may cause significant discontinuity in the index level.
Finally, an equity index will be accurate only to the extent that:
the component securities in the index are being traded
the prices of these securities are being promptly reported
the market prices of these securities, as measured by the index, reflect price movements in the relevant markets
By Boris Dzhingarov
© 2015 Copyright Boris Dzhingarov - All Rights Reserved
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