Types of indexes for indices trading

Indexes are a great way to track how a particular asset or market is doing. The three most common types of indexes for indices trading are price-weighted, value-weighted and market capitalization weighted. This article will explain what these three types of indexes do and when you should use them.

Price-weighted Indexes

The most common type of equity market index is the price-weighted index. In this index, each member receives its weight based on its market capitalization (i.e., the total value of all outstanding shares).

  • Like any other price-weighted average, a price-weighted index considers the value of an underlying asset class. The difference between this average and others is that each stock within the group has a different weighting based on its market capitalization (i.e., its size). If you’re looking at a typical stock market index like the S&P 500, for example, larger companies like Apple Inc. or Alphabet Incorporated would have a heavier influence on tracking changes in overall market performance than something more minor like American Airlines Group Inc or United Continental Holdings Inc.
  • For example, if a company has 1 million outstanding shares and a stock price of $100 per share, its total market capitalization is $100 million. If every other company in that index had an equal number of outstanding shares as this one company and traded at $50 per share (for a total market capitalization of $50 million), then this first company would have twice as much weight in the index as any other member even though it represents just 4% more actual money invested ($4MM vs $3MM).

Value-Weighted Indexes

Value-weighted indexes are based on the value of each company. The index is weighted by its market capitalization, which means that companies with larger market caps will significantly influence the overall index’s direction. This weighting can be seen as a measure of how vital each company is to the overall economy. For example, use an industry-specific value-weighted index to track significant companies in your industry.

For example, let’s say we want to create an index that tracks only prominent technology companies and compare it against another similar one made up only of small tech firms (although we could also do this for other industries). Then we would need two separate indices:

  • Large Tech Value Index: Tracks large tech stocks like Microsoft and Apple using their total market capitalizations as weights
  • Small Tech Index: Tracks smaller technology firms using their share prices as weights

Market Capitalization-Weighted Indexes

Market capitalization-weighted indexes are the most popular type of index. They are weighted by the market value of the companies in the index, not by their share prices. This means that companies with higher market values have a more significant influence on the index.

To illustrate this concept, consider two hypothetical companies: Blue Chip Company (BCC), which has $100 million in market capitalization and a share price of $1, and Penny Stock Company (PSC), which has $10 million in market capitalization and a share price of $0.10. In an equal-weighted index, each company would account for 10% of its overall weighting — BCC would make up 10% while PSC would make up 2%. In contrast, if we were to use a cap-weighted index where BCC accounts for 90% while PSC only accounts for 10%, we see how much more impact BCC can have on its overall returns compared to PSC’s returns despite their relative differences in size and value when measured by share price alone.

As you can see, the world of indices trading is a complex and ever-evolving one. It’s not just about finding the right stocks to buy and sell; it’s also essential to understand what kind of index you’re using and why certain stocks are included or excluded from each type of index.

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