We have understood what an exchange is and how we can trade on the same. In this article let’s discuss “market index”. We keep reading in newspapers that Nifty is up or that Sensex is down. Let’s try to understand what these up and down movements actually mean. Nifty and Sensex are the market indices of National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) respectively. The market index is what is most commonly tracked and followed by all market participants to get a broad understanding of general direction of market movement.
Let’s try to understand this through an example. Suppose you want to understand the price movement in real estate sector in a particular city. If a property buyer offered you a high price for a piece of property that you bought last year, and based on the same you conclude that real estate price across the city is trending up, then there is a high possibility that you are wrong. There are different types of properties available in the market: agricultural land, commercial land, residential land, office space for renting, bungalows, flats etc. There are a multitude of reasons why price of any of these types of properties might be increasing/decreasing. Some of the reasons causing price movement might be common to all types of properties and other reasons might be affecting only specific property type. In general, when population is increasing in a locality and land is becoming scarce, prices of all kinds of properties go up. So this is a common factor affecting all kinds of properties. But there might be a situation where demand and price of commercial properties are decreasing because companies are shifting their base out of the city, while demand and price of residential flats are increasing because people, whose personal income is increasing, are buying second homes. Thus, if we want to conclude something about the real estate market in a city, we cannot do that just by looking at price movements in a single locality or in a single property type. However if we create a representative basket which includes some properties from all these types and from different location across the city, then we will be able to better observe general price trends and conclude direction of price movement in the sector.
A market index serves as a benchmark that allows us to understand general price movement of stocks on the exchange. As discussed in the first article, many companies are listed on the stock exchange. If we just look at price movement of one company to decide general trend in price movement across market, our conclusion will most likely be incorrect. First we will need to create a basket of sample stocks as was suggested in the earlier example. Including most frequently traded stocks from different sectors of the market like banking, pharma, IT, metals etc. will give best results. Once the basket is created we can observe the price movement of the stocks within, to conclude the general price trend of the market.
Nifty is a sample of 50 listed and frequently traded stocks on NSE, selected from across different sectors. Similarly, Sensex is a sample of 30 stocks from across different sectors all listed on BSE.
Read on to understand what an index is and how it is constructed.