Skip to main content
   


 Practical uses of the Index


Some of the practical uses of Index are discussed below.

Information – The index reflects the general market trend for a period of time. The index is a broad representation of the country’s state of economy. A stock market index that is up indicates people are optimistic about the future. Likewise when the stock market index is down it indicates that people are pessimistic about the future.
For example the Nifty value on 1st of January 2014 was 6301 and the value as of 24thJune 2014 was 7580. This represents a change of 1279 points in the index of 20.3% increase. This simply means that during the time period under consideration, the markets have gone up quite significantly indicating a strong optimistic economic future.
The time frame for calculating the index can be for any length of time.. For example, the Index at 9:30 AM on 25th June 2014 was at 7,583 but an hour later it moves to 7,565. A drop of 18 points during this period indicates that the market participants are not too enthusiastic.

Benchmarking – For all the trading or investing activity that one does, a yardstick to measure the performance is required.  Assume over the last 1 year you invested Rs.100,000/- and generated Rs.20,000 return to make your total corpus Rs.120,000/- . How do you think you performed? Well on the face of it, a 20% return looks great. However what if during the same year Nifty moved to 7,800 points from 6,000 points generating a return on 30%?
Well suddenly it may seem to you, that you have underperformed the market! If not for the Index you can’t really figure out how you performed in the stock market. You need the index to benchmark the performance of a trader or investor. Usually the objective of market participants is to outperform the Index.

Trading – Trading on the index is probably one of most popular uses of the index. Majority of the traders in the market trade the index. They take a broader call on the economy or general state of affairs, and translate that into a trade.
For example imagine this situation. At 10:30 AM the Finance Minister is expected to deliver his budget speech. An hour before the announcement Nifty index is at 6,600 points. You expect the budget to be favorable to the nation’s economy. What do you think will happen to the index? Naturally the index will move up. So in order to trade your point of view, you may want to buy the index at 6,600. After all, the index is the representation of the broader economy.
So as per your expectation the budget is good and the index moves to 6,900. You can now book your profits, and exit the trade at a 300 points profit!  Trades such as these are possible through what is known as ‘Derivative’ segment of the markets. We are probably a bit early to explore derivatives, but for now do remember that index trading is possible through the derivative markets.

Portfolio Hedging – Investors usually build a portfolio of securities. A typical portfolio contains 10 – 12 stocks which they would have bought from a long term perspective. While the stocks are held from a long term perspective they could foresee a prolonged adverse movement in the market (2008) which could potentially erode the capital in the portfolio. In such a situation, investors can use the index to hedge the portfolio.

 Index construction methodology

It is important to know how the index is constructed /calculated especially if one wants to advance as an index trader. As we discussed, the Index is a composition of many stocks from different sectors which collectively represents the state of the economy. To include a stock in the index it should qualify certain criteria. Once qualified as an index stock, it should continue to qualify on the stated criteria. If it fails to maintain the criteria, the stock gets replaced by another stock which qualifies the prerequisites.
Based on the selection procedure the list of stocks is populated. Each stock in the index should be assigned a certain weightage. Weightage in simpler terms define how much importance a certain stock in the index gets compared to the others.  For example if ITC Limited has 7.6% weightage on Nifty 50 index, then it is as good as saying the that the 7.6% of Nifty’s movement can be attributed to ITC.
The obvious question is – How do we assign weights to the stock that make up the Index?
There are many ways to assign weights but the Indian stock exchange follows a method called free float market capitalization. The weights are assigned based on the free float market capitalization of the company, larger the market capitalization, higher the weight.
Free float market capitalization is the product of total number of shares outstanding in the market, and the price of the stock.
For example company ABC has a total of 100 shares outstanding in the market, and the stock price is at 50 then the free float market cap of ABC is 100*50 = Rs.5,000.
At the time of writing this chapter, the following are the 50 stocks in Nifty as per their weightage…

Sl NoName of the companyIndustryWeightage (%)
01ITC LimitedCigarettes7.60
02ICICI Bank LtdBanks6.55
03HDFC LtdHousing Finance6.45
04Reliance Industry LtdRefineries6.37
05Infosys LtdComputer Software6.26
06HDFC Bank LtdBanks5.98
07TCS LtdComputer Software5.08
08L&T LtdEngineering4.72
09Tata Motors LtdAutomobile3.09
10SBI LtdBanks2.90
11ONGC LtdOil Exploration2.73
12Axis Bank LtdBanks2.50
13Sun Pharma LtdPharmaceuticals2.29
14M&M LtdAutomobiles2.13
15HUL LtdFMCG1.87
16Bharti Airtel LtdTelecom Services1.70
17HCL Technologies LtdComputer Software1.61
18Tata Steel LtdMetal -Steel1.42
19Kotak Mahindra Bank LtdBanks1.40
20Sesa Sterlite LtdMining1.38
21Dr.Reddy’s Lab LtdPharmaceuticals1.37
22Wipro LtdComputer Software1.37
23Maruti Suzuki India LtdAutomobile1.29
24Tech Mahindra LtdComputer Software1.24
25Hero Motocorp LtdAutomobile1.20
26NTPC LtdPower1.15
27Power Grid Corp LtdPower1.13
28Asian Paints LtdPaints1.10
29Lupin LtdPharmaceuticals1.09
30Bajaj Auto LtdAutomobile1.07
31Hindalco Industries LtdMetal – Aluminum0.95
32Ultratech Cements LtdCements0.95
33Indusind Bank LtdBanks0.94
34Coal India LtdMining0.93
35Cipla LtdPharmaceuticals0.89
36BHEL LtdElectrical Equipment0.79
37Grasim Industries LtdCements0.79
38Gail (India) LtdGas0.78
39IDFC LtdFinancial Services0.74
40Cairn India LtdOil Exploration0.72
41United Sprits LtdDistillery0.70
42Tata Power Co.LtdPower0.68
43Bank of BarodaBanks0.63
44Ambuja Cements LtdCements0.61
45BPCLRefineries0.58
46Punjab National BankBanks0.55
47NMDC LtdMining0.52
48ACC LtdCements0.50
49Jindal Steel & PowerSteel0.38
50DLF LtdConstruction0.34
As you can see, ITC Ltd has the highest weightage. This means the Nifty index is most sensitive to price changes in ITC Ltd, and least sensitive to price changes in DLF Ltd. 

 Sector specific indices


While the Sensex and Nifty represent the broader markets there are certain indices that represents specific sectors. These are called the sectoral indices. For example the Bank Nifty on NSE represents the mood specific to the banking industry. The CNX IT on NSE represents the behavior of all the IT stocks in the stock markets. Both BSE and NSE have sector specific indexes.  The construction and maintenance of these indices is similar to the other major indices.

Comments

Post a Comment

Popular posts from this blog

Axis Bank to sell 9% to Bain Capital, others to raise Rs 11,625 crore

The board of Axis Bank on Friday approved stake sale to private equity player Bain Capital and other investors in its bid to raise capital by issue of equity linked securities on a preferential basis. The board of Axis Bank on Friday approved a 9 percent stake sale to Bain Capital and other investors including LIC in its bid to raise capital worth Rs 11,626 crore by issue of equity of equity linked securities on a preferential basis. The issue price of equity Shares at Rs 525 per share while the issue price of convertible warrants is Rs 565 per share. Entities affiliated with Bain Capital propose to invest Rs. 6,854 crore while LIC or Life Insurance Corporation will be issued around 3.02 crore equity shares on a preferential basis to help the bank raise over Rs 1,583 crore, the bank said. Approved by the Board today, Axis Bank proposes to raise Rs 9,063 crore through issuance of equity and the remaining Rs 2,563 crore through issue of warrants. The capital raise ...
Post a Comment
Read more
THE NIFTY FUTURE  Basics of the Index Futures Within the Indian derivatives world, the Nifty Futures has a very special place. The ‘Nifty Futures’ is the most widely traded futures instrument, thus making it the most liquid contract in the Indian derivative markets. In fact you may be surprised to know that Nifty Futures is easily one of the top 10 index futures contracts traded in the world. Once you get comfortable with futures trading I would imagine, like many of us you too would be actively trading the Nifty Futures. For this reason, it would make sense to understand Nifty futures thoroughly. As we know the futures instrument is a derivative contract that derives its value from an underlying asset. In the context of Nifty futures, the underlying is the Index itself. Hence the Nifty Futures derives its value from the Nifty Index. This means if the value of Nifty Index goes up, then the value of Nifty futures also goes up. Likewise if the value of Nifty Index decl...
Post a Comment
Read more

OPTION TRADING

A Special Agreement There are two types of options – The Call option and the Put option. You can be a buyer or seller of these options. Based on what you choose to do, the P&L profile changes. Of course we will get into the P&L profile at a much later stage. For now, let us understand what “The Call Option” means. In fact the best way to understand the call option is to first deal with a tangible real world example, once we understand this example we will extrapolate the same to stock markets. So let’s get started. Consider this situation; there are two good friends, Ajay and Venu. Ajay is actively evaluating an opportunity to buy 1 acre of land that Venu owns. The land is valued at Rs.500,000/-. Ajay has been informed that in the next 6 months, a new highway project is likely to be sanctioned near the land that Venu owns. If the highway indeed comes up, the valuation of the land is bound to increase and therefore Ajay would benefit from the investment he would mak...
Post a Comment
Read more