Stock indices (e.g. the Nasdaq 100, the FTSE 100, the CAC 40, etc.) are financial markets that are based upon at least several (and usually many) underlying individual stocks (e.g. XYZ company, etc.). While stock indices are financial markets unto themselves, the prices of stock indices are calculated using the prices of their underlying individual stocks, but not always (read as not usually) using the most direct calculation.
Direct and Indirect Stock Index Calculation
As an example of a direct stock index calculation, a stock index might consist of twenty five underlying individual stocks, whose prices could simply be added together (e.g. price of stock # 1 + price of stock # 2 + ... = price of stock index) to create the price of the stock index.
As an example of an indirect stock index calculation (which is much more likely), a stock index might consist of twenty five underlying individual stocks, whose prices are added together, then divided by twenty five (the number of underlying individual stocks), the result of which is multiplied by the average trading turnover of each of the underlying individual stocks (i.e. the financial value of each individual stock's trading), which are then added together to create the trading turnover weighted price of the stock index.
Some Stocks Are More Equal Than Others
One of the significant differences between a directly calculated stock index and an indirectly calculated stock index is the value (as in importance, not financial value) that is given to each underlying individual stock.
For a directly calculated stock index, the underlying individual stocks are valued equally (i.e. each underlying individual stock is as important as all of the other underlying individual stocks). For an indirectly calculated stock index, the underlying individual stocks are valued unequally (i.e. some of the underlying individual stocks are more important (i.e. they have more effect on the price of the stock index) than some of the other underlying individual stocks).
The underlying individual stocks that are considered more important will have a greater effect on the price movement of the stock index than the underlying individual stocks that are considered less important.
For example, an underlying individual stock that has twice the trading turnover of another underlying individual stock, will have twice the effect on the price movement of a trading turnover weighted stock index. While every one point increase in the price of the more important underlying individual stock might cause the price of the stock index to increase by one point, every one point increase in the price of the less important underlying individual stock might cause the price of the stock index to increase by only half a point.
Knowing How a Stock Index is Calculcated Can Improve Your Trading
Knowing how a stock index is calculated, or more specifically knowing which underlying individual stocks are the most important for the calculation of the stock index, can be useful for trading the stock index itself.
For example, a trader that is considering a long trade on XYZ stock index, could analyze the underlying individual stocks that are considered important for XYZ stock index to determine if they are in agreement with the long trade. If the important underlying individual stocks were in agreement with the long trade (i.e. were also bullish), that would be a very good confirmation of the long trade, but if the important underlying were in disagreement with the long trade (i.e. were bearish), then that could be a negation of (or at least a warning against) the long trade.
How is XYZ Stock Index Calculated?
Each stock index is calculated according to its own calculation which can range from relatively straightforward to rather complex (as shown by the above examples). The calculation that is used for a particular stock index is usually available via the web site of the exchange that provides the stock index (but not always).
