If you follow the daily market update, you often come across the headlines’ NIFTY hits <XXX>, and SENSEX falls below <XXX>, what does it signal for tomorrow’s trade?‘. NIFTY and SENSEX are the indices of the stock market exchanges National Stock Exchange (NSE) and Bombay Stock Exchange (BSE), respectively.
A stock market index is the statistical measure of the performance of the market, reflecting the ups and downs in it. It indicates the overall sentiment of the market. Why do we need an index?
The stock exchanges have thousands of companies listed on them. A retail investor needs to analyse each security and do the math to calculate the market’s average performance. To solve the problem, the exchanges have their indices that track the performance of a group of securities (chosen based on different criteria) and represent the average performance of the underlying group.
Classification of stock market indices
The classification of stock market indices is extensive. There are 3 primary indices used in India based on their popularity:
Benchmark Indices: The securities that are considered to be concise, well-performing, use important regulatory practices, etc. are grouped. They are used as points of reference to measure the performance of the market. Eg: NSE NIFTY 50, BSE SENSEX
Sectoral Indices: These are created to track the performance of specific sectors like technology, finance, healthcare, etc.Eg: BANKNIFTY, S&P BSE Energy
Market Cap Indices:These indices group companies only based on their market capitalization. Eg: S&P BSE SmallCap, NIFTY Midcap, etc
Important Indices of India
BSE SENSEX
The term Sensex refers to the benchmark index of the Bombay Stock Exchange (BSE) in India. The Sensex comprises 30 of the largest and most actively traded stocks on the BSE. Learn more about the Sensex here. Only BSE Sensex is tradable in F&O.
Other than SENSEX, click here to see the list of other BSE indices.
NSE NIFTY
Nifty is a popular stock market index introduced by the National Stock Exchange (NSE). ‘Nifty’ is a mix of the words “National Stock Exchange” and “fifty.” NIFTY 50 is a flagship benchmark index of the NSE showcasing the 50 top-performing equity stocks trading on the platform. Learn more about NIFTY here.
Check out the NSE index dashboard for equity and fixed income indices of NSE.
According to SEBI, futures & options contracts on an index can be introduced if the stocks contributing to 80% weightage of the index are individually eligible for derivatives trading. However, no single ineligible stock in the index shall have a weightage of more than 5% in the index. Only NIFTY 50, BANK NIFTY, NIFTY FINANCIAL SERVICES are tradable in F&O.
Indices play a crucial role in the stock market. They are essential for studying the market and determining the performance of the stocks. Without these indices, the stock market will be chaotic and directionless.
An index fund is also one of the preferred investment choices for long-term investors.
What is index arbitrage?
Index arbitrage (also called ‘basis trading’) is the style of arbitrage wherein an investor attempts to make a profit from the difference in the actual price of the stock and the predicted or misrepresented futures price. The time gap to carry out an index arbitrage strategy is very narrow due to current prices not reflecting the most recent information.
In order to spot index trading opportunities, investors use program trading techniques that monitor a stock index as well as any futures contracts that are on it. If they spot a difference, they can seamlessly execute the order by simultaneously buying or selling the future or the stock.
Challenges Associated with Index Arbitrage
In case you are an individual investor or retail investor, you may find it tough to make a profit from index arbitrage in the following situations:
Window of opportunity is narrow: It is hard to spot differences dealing with two different quotes within the usual small time frame, especially for someone who is working manually and not using software for their index arbitrage trading. The quoted price at which one wants to sell off their securities could change at any second and cause potentially huge losses for the trader, due to the high volumes traded,
Expensive hi-tech required: Program trading allows opportunities for arbitrage to be predicted so one can take advantage of differently quoted prices in the future.
High transaction costs: Since index arbitrage requires simultaneous buying and selling of a high volume of stocks, transaction costs can be high, as they occur every time one buys and sells a security (actual cost depending upon one’s brokerage).
Index weightage models in India
A stock market index combines several stocks selected based on different price values, and the proportion of price change differs for each share. During the construction of an index, each scrip receives a particular weight based on the calculation method used. The most common index weighting model used in India is Market- cap weightage.
Market cap or market capitalisation refers to the cumulative value of all stock shares of a company. It is determined by multiplying the total number of outstanding shares with the price of the stock. In market cap weightage, companies with large market cap are grouped to form the index.
Indian bourses use the free-float market capitalisation method of index calculation.
In the free-float market capitalisation method, the company’s value is determined only by the publicly held shares (excluding shares held by the promoters). The result of the free float method reflects market performance more accurately than any other method.
Why are stock indices important?
Acts as a Representative:As mentioned above, the index reflects the ongoing trend of the market. If the stock market index is bullish, it represents a flourishing market and thus a growing economy. If the stock market index is bearish, it represents a downward trend in the market activity and a slowdown in the economy
Grouping/Sorting: Any index consists of a group of stocks carefully chosen on certain criteria. Index will have the best-performing stocks (based on the criteria of grouping) in one place helping investors manage their portfolio.
Acts as a Benchmark: Index acts as a standard to measure the performance of a stock. One can find out if the stock is performing better or worse compared with the benchmark index
Investment:Investing in indices, whether investing in index funds or index-based ETFs or trading in indices or small-cap, is one of the chosen strategies where you invest in a basket of scrips across diversified sectors averaging the risk exposure compared to the individual stocks.
Conclusion:
Index Arbitrage is a useful avenue for low-risk profits, especially for traders with a large corpus of funds. To know more about stock markets, visit the Angel One website.
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