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Most of us have heard the term stock index before, but only a few of us know exactly what this term means. We would like to explain it to you and in the following we will deal with stock indices and their function in stock exchange trading.
What is a stock index?
The stock index is a key figure that shows the price development of different securities in a “basket of shares”. There are innumerable stock corporations in the world from the most diverse industries.
A basket of shares can be composed of the shares of companies in a country or in a particular industry. The index of this basket of shares represents the performance of all the shares it contains and such indices can be found in many countries around the world. The price is primarily influenced by the price development of all shares, but the weighting of the individual shares also plays a role.
Types of stock indices
There are different types of indices and these include:
- Global or world market indices: Such an index shows the performance of the largest companies in the world. Thus, the MSCI index is one of the most important stock indices worldwide. It comprises the performance of around 1,600 shares from 23 industrialized countries and is used by many investors as a benchmark for their own investment strategy.
- National Indices: An index of this kind represents the performance of the stock market in a particular country.
- Sector indices: These indices are designed to reflect the performance of shares in sectors or industries.
In addition to equities, there are other markets for which indices can be found, such as currencies, commodities or even sentiment indices, which measure expectations of market volatility.
What is the purpose of a stock index?
A stock index can give a very good impression of the economic situation of a country or industry at a glance. Leading indices of industrialized countries are also called “stock market barometers”. Stock indices such as the Nikkei 225 or the Dow Jones are among the world’s most important indices and, for their part, represent the economic situation of the largest economies – and thus of the entire world. The American stock index S&P 500 plays a special role. As an indicator of the economic situation in the USA, the index is considered a barometer of sentiment for the entire stock market.
How is a stock index calculated?
To show how a stock index is calculated, let’s look at a concrete example using the Dax index. The abbreviation DAX stands for “Deutscher Aktienindex” (German Stock Index) and this is a summary of the performance of the shares of the 30 largest and highest-turnover companies in the country. The Dax was launched by Deutsche Börse in 1988, with an initial price of 1,000 points.
Originally, the Dax was only introduced as a supplement to the other indices, but in the course of time it has developed into the globally recognized main index of the country’s stock market landscape.
The exact calculation of an index from the individual stocks is done with the help of a long and complicated formula developed by the German economist and statistician Étienne Laspeyres in 1871. This formula gives the individual stocks within an index different weightings. In the case of the Dax, this means that the 30 members of the index do not have the same degree of influence on price performance.
A small example:
Let’s assume that Siemens AG is weighted at 9.46 percent in the Dax. If the company’s share price rises or falls by ten percent, it means a change of almost one percentage point in the index. If the Adidas share price were to change by ten percent, this would mean a difference of 0.16 percentage points in the index.
The weighting of the individual Dax members depends on the value of the shares, which are freely tradable and not considered to be fixed-interest. The weighting is based on the free float market capitalization. This means that the total stock market value of a stock corporation is not taken as a basis – if a shareholder holds more than five percent of the shares of a company, this share is referred to as fixed ownership and is not included in the Dax.
Incidentally, a maximum weighting of ten percent per Dax member is possible. The weightings do not always remain the same either; they are adjusted regularly and result from changes in the share price and also from changing ownership structures.
Different weighting regulations
The Dax index is a capitalization-weighted index. There are also two other ways of weighting the individual stocks in an index:
Price-weighted index: Here, each of the selected shares in the index is found with the same number of units. The respective weighting is largely determined by the level of the price. Such indices include, for example, the Nikkei 225.
Balanced index: All individual stocks have the same weighting. If an index consists of 25 shares, for example, each of them has a weighting of four percent.
The most important stock indices worldwide
In the last section, let us take a look at the most important international stock indices. We have already got to know the Dax and it is not the only important index in this country:
- TecDAX: This index tracks the performance of 30 of the country’s 35 largest technology companies. Introduced in March 2003, the current companies include Xing AG, Telefonica Deutschland AG and Freenet AG.
- MDax: This index includes 50 medium-sized companies. These stock corporations are compiled from the 60 companies that rank behind the Dax in terms of stock exchange turnover and market capitalization. The composition of the index is recalculated twice a year. The MDax was introduced in 1996.
- SDax: The companies in the MDax are followed by 50 small companies which are represented by the SDax. The selection of stocks is reviewed on a quarterly basis.
- Important international indices
- Dow Jones: This index was introduced in 1896 and is one of the three major stock market barometers. The index consists of shares of the 30 largest companies in the country.
- Eurostoxx 50: This index has been calculated since 1998 and includes securities of the 50 most important companies in the euro countries.
- Nikkei: This is a Japanese index and consists of the shares of the 225 leading companies in the country. This index has existed since 1949.
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