Practical uses of the Index stock

Some of the practical uses of Index are discussed below. 

Information – The index reflects the general market trend for a period of time. The index is a broad representation of the country’s state of economy. A stock market index that is up indicates people are optimistic about the future. Likewise when the stock market index is down it indicates that people are pessimistic about the future.

 For example the Nifty value on 1st of January 2014 was 6301 and the value as of 24th June 2014 was 7580. This represents a change of 1279 points in the index of 20.3% increase. This simply means that during the time period under consideration, the markets have gone up quite significantly indicating a strong optimistic economic future. 

 The time frame for calculating the index can be for any length of time.. For example, the Index at 9:30 AM on 25th June 2014 was at 7,583 but an hour later it moves to 7,565. A drop of 18 points during this period indicates that the market participants are not too enthusiastic.

Benchmarking – For all the trading or investing activity that one does, a yardstick to measure the performance is required. Assume over the last 1 year you invested Rs.100,000/- and generated Rs.20,000 return to make your total corpus Rs.120,000/- . How do you think you performed? Well on the face of it, a 20% return looks great. However what if during the same year Nifty moved to 7,800 points from 6,000 points generating a return on 30%? 

 Well suddenly it may seem to you, that you have underperformed the market! If not for the Index you can’t really figure out how you performed in the stock market. You need the index to benchmark the performance of a trader or investor. Usually the objective of market participants is to outperform the Index. 

  Trading - Trading on the index is probably one of most popular uses of the index. Majority of the traders in the market trade the index. They take a broader call on the economy or general state of affairs, and translate that into a trade.

 For example imagine this situation. At 10:30 AM the Finance Minister is expected to deliver his budget speech. An hour before the announcement Nifty index is at 6,600 points. You expect the budget to be favorable to the nation’s economy. What do you think will happen to the index? Naturally the index will move up. So in order to trade your point of view, you may want to buy the index at 6,600. After all, the index is the representation of the broader economy. 

 So as per your expectation the budget is good and the index moves to 6,900. You can now book your profits, and exit the trade at a 300 points profit! Trades such as these are possible through what is known as ‘Derivative’ segment of the markets. We are probably a bit early to explore derivatives, but for now do remember that index trading is possible through the derivative markets. 

  Portfolio Hedging – Investors usually build a portfolio of securities. A typical portfolio contains 10 – 12 stocks which they would have bought from a long term perspective. While the stocks are held from a long term perspective they could foresee a prolonged adverse movement in the market (2008) which could potentially erode the capital in the portfolio. In such a situation, investors can use the index to hedge the portfolio. We will explore this topic in the risk management module.