A stock index is a compilation of several stock prices into a single number. Indexes come in various shapes and sizes. Some are broad-based and measure moves in diverse markets. Others are narrow-based and measure more specific industry sectors of the marketplace.
It is not the average number of stocks that that determines if an index is broad-based or narrow-based. Rather, it is the diversity of the underlying securities and their market coverage. Different stock indexes are calculated in different ways. Even where indexes are based on identical securities, they may measure the relevant market differently because of differences in methods of calculation.
An index can be constructed so that weightings are biased toward the securities of larger companies. This method of calculation is known as capitalization-weighted. To calculate index value, the market price of each component security is multiplied by the number of shares outstanding. This allows a security’s size and capitalization to have a greater impact on the value of the index.
Another type of index is known as equal dollar-weighted. This index assumes an equal number of shares of each component stock. It is calculated by first establishing an aggregate market value for every component security of the index. Then, by dividing the aggregate market value by the current market price of the security. This determines the number of shares of each security. This method of calculation does not give more weight to price changes of the more highly capitalized component securities.
An index can also be a simple average. It can be calculated by adding up the prices of the index’s securities and dividing by the number of securities, disregarding numbers of shares outstanding. Another type measures daily percentage movements of prices by averaging the percentage price changes of all securities included in the index.
Adjustments & Accuracy
Securities may be dropped from an index because of events such as mergers and liquidations or because a particular security is no longer considered representative of the types of stocks in the index. Securities may also be added to an index occasionally.
Adjustments to indexes might be made because of substitutions or following the issuance of new stock by a component security. Such adjustments and other similar changes are within the discretion of the index’s publisher. They will not usually cause any adjustment in the terms of outstanding index options. However, an adjustment panel has authority to make adjustments if the publisher of the underlying index makes a change in the index’s composition or method of calculation that, in the panel’s determination, may cause significant discontinuity in the index level.
Finally, an equity index is accurate only to the extent that:
- The component securities in the index are being traded.
- The prices of these securities are being promptly reported.
- The market prices of these securities, as measured by the index, reflect price movements in the relevant markets.
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