Welcome back to this next Smart Money Club Introduction to Financial Basics lesson. In today’s lesson, we will be continuing our discussion of stock indexes, going into the specifics of how their prices are calculated and how best to trade them. With this knowledge, we will be taking your trading to the Power of X. Let’s get right to it!!!!
Calculating Stock Indexes
One of the first questions that we will need to ask and answer for ourselves if we are interested in trading a particular index is, “How is its price calculated?”
Most major indices will be calculated either using one of two methods:
- Capitalization weighting
- Price weighting
Let’s look at each of these different methods so we can understand how the index’s price will be affected.
The Capitalization Weighted System
This system, also known as market value-weighted, is used by the majority of stock indexes. A capitalization-weighted index takes the size of each of the constituent companies into account when it is calculating the value of the entire index. Therefore, the more that a particular company is worth, the more that a change in its share price will affect the total value of the index.
You can determine how much a particular company is worth by finding its market capitalization or “market cap.” You can find the market cap by simply multiplying the current share price by the number of issued shares.
The S&P 500 is certainly the most well-known capitalization-weighted index, and it contains many of the U.S.’s most well-established companies.
If, for example, two constituent companies of the S&P500, Boeing Co. (B.A.) closed down 2.5% to $365/share while Microsoft Corp. (MSFT) closed down -2.5% to $115/share. Boeing had a market cap of $205 billion, a weight of less than 1% of the S&P, and Microsoft’s market cap was $902 billion, over 3% of the S&P. Though they had a similar price decline, Microsoft’s decline had three times the effect on the S&P price than Boeing due to its large market cap.
Other indexes that use this system include the NASDAQ-100, Hang Seng, CAC 40, FTSE100, and ASX 200.
The Price-Weighted System
This method takes the actual share price of the index’s constituent companies and totals them up rather than the company’s overall size to determine the index’s total value.
The higher the particular compy’s share price, the more influence that company has on the value of the index.
For example, a stock trading at $1,000 would have five times more influence on the price-weighted index than a company trading at just $200.
The two major global indices that use this system are the Dow Jones Industrial Average (which uses 30 stocks) and Japan’s Nikkei 225.
Quiz
The imaginary Global ABC index is capitalization-weighted, and it represents the total value of the following three stocks:
- Company A has a share price of $1 with ten shares issued
- Company B has a share price of $2 with 20 shares issued
- Company C has a share price of $5 with 50 shares issued.
What is the value of the Global ABC index in Dollars?
You can find the answer to this quiz at the end of the lesson.
How do you trade stock indexes?
Because indexes are effectively just calculated numbers, you can’t buy or sell them directly. There’s no asset to own and nothing to be exchanged. Therefore, to trade on the price of an index, you need to choose a product that mirrors the index’s performance. There are several ways for you to do this:
Index funds
These are specialized investment funds that attempt to replicate the movements of a particular stock index. You can invest in index funds through a fund manager, but they are not easily traded.
Exchange-traded funds (ETFs)
These are distinct types of index funds that can be traded like a stock on an exchange. Just like stocks, the price of ETFs will change throughout the trading day as they are bought and sold. Currently, the world’s largest ETF tracks the S&P500 and is aptly named the “SPDR S&P 500.” There are ETFs that track nearly every index and subsets of those indexes as well.
Derivatives
Derivatives are financial products that derive their prices from the performance of an underlying asset or “instrument.” For example, futures, options, digital 100s, spread bets, and contracts for differences (CFDs) are all derivatives, and there are all of these derivatives available for trading indexes.
Lesson Summary
In this Smart Money Club lesson, we learned that the more common capitalization-weighted indexes are calculated based on the size of their component companies. In contrast, price-weighted indices use the share price and total these up. You cannot trade indexes directly because they are just numbers; you must use funds or derivatives to do so.
In our next lesson, we’re taking you to the Power of X, learning about foreign currency exchange or Forex.
Answer to the Quiz
The value of the Global ABC Index:
= (1 x $10) + (2 x $20) + (5 x $50)
= $10 + $40 + $250
= $300
