What on earth is this 'Index'?!!
To become successful at anything, understanding in detail is a must.
Here's an intriguing fact: 'Only 2% of traders make money consistently'
The main reason I personally think people make losses is that they don't know their basics.
The more aware you are of the basics, the more likely you are to: make a profit, follow a plan and most importantly not get greedy!
As a reader of SimpleTrading, you have proven you are eager to learn and so, you, my friend are going to learn a few basics that will give you an edge over a large number of ignorant traders.
Today we will explore, in simple terms, one thing that everyone talks about but very few really know what it is- Nifty, Sensex, Bank Nifty, Dow Jones- refered to as Indexes
India, and for that matter any country, has companies that are involved in a variety of activities from which incomes are earned.
All these companies be it car manufacturers, IT companies, banks, cloth makers, casinos, sugar factories, movie makers etc. together represent the entire nations financial health.
However, despite having many activities going on, a select few represent a major part of a country's activities.
For e.g., Saudi Arabia generates most of its money from selling oil. It does have hotels and banks and car makers, but they are not as significant as the oil industry.
So if oil makers are making a decent profit in Saudi, but hotels are making losses, still we could say that overall, the country Saudi Arabia is doing well. Thus one single sector could represent the financial status of a country.
Whereas, unlike Saudi, India has more than one one major business activity. A large portion of India can be represented by the following sectors (apart from agriculture):
1. Financial Services
2. IT companies
3. Energy Companies (Fuels like coal, oil and Electricity)
4. Automobile makers
5. Pharmaceuticals (Medicine makers)
6. Metal (Steel, aluminium sellers)
7. Consumer goods (Toothpastes, soaps)
8. Cigarettes (Yes, India makes a lot of cigarettes!)
9. Telecom (Airtel, Idea)
10. Cements and chemicals
and a few more..
A large part of Indian population must be earning its money directly or indirectly from the above 10 industries, either working there as managers or workers or even running smaller businesses that supply to these companies.
Overall, India's fortunes and wealth are mainly linked to these few sectors. So, if we had a way to track these, a way to assess the way they are doing, we could get a way to judge India on a whole right?
And this is exactly what an Index aims to do, the idea behind an index is simple, take the top companies in their respective key sectors and assign them a weight based on how important they are to India, and then it will be easy to track the nation!
This is what Nifty, Sensex, Hang Sen, Dow Jones etc. are, just a way of tracking and representing a country on a large scale.
And this can be extended even further, to track only how finance sector is doing, take the major banks and other finance institutions that represent a large part of India and you can track the whole finance sector as a whole.
We called this index Bank Nifty
Take the major IT Companies and they will represent the IT sector as a whole. Nifty IT
Take the major pharmaceutical companies and they will represent the Pharma sector as a whole. Nifty Pharma
Just to sum up, an Index is just a selection of the major Companies in a Country/ Sector to give a representation of a it as a whole.
We do this all the time, in Bangalore, even though there are many companies we still call it the IT hub because a lot of the companies are IT related. So IT represents a large part of Banglore
So Nifty tracks India's core sectors with differing importance, here's how Nifty is divided:
Nifty is made up of 50 stocks, Sensex is made of 30 stocks, BankNifty of 10-12 (changes frequently).
Now, from these sectors, top companies are selected like TCS, Infosys to represent IT, HDFC, Kotak to represent Finance, ITC to represent cigaretts, Airtel to represent Telecom and so on.
Each stock affects the index by its movement, but all stocks are not weighted equally either since, TCS (IT) or HDFC (finance) would affect India more than a move in Zee Entertainment (Media).
What investors and traders think about these stocks, usually represents what they think of those sectors, and what they think of those sectors, put together, represents what they think of that country.
Since an Index is the total movement in the prices of individual stocks like these, they causes the Index to move on a minute to minute basis.
Here you can find company wise weights in the Nifty:
So now, you can understand:
1. Why Indexes matter so much - why if Nifty falls, people worry so much and when it rises why they are happy.
2. Why if just a handful of companies like TCS, HDFC, ITC and Reliance move, suddenly NIFTY moves as well.
3. Since Indexes are made of stocks, which we can trade, there has to be a way to trade the Index.
I hope you enjoyed this post, and will now remember this for life. To test how well you understand, I is suggested to explain things to a 10 year old, so try doing that, and you'll be amazed at how simple a concept this is.
Next post will be on Futures and Options and then we can progress to more complex topics slowly.
Till then, stay tuned and share this blog with other! Subscribe for alerts and Contact me for feedback, doubts and suggestions or reach me on Facebook.
Thank you for reading and happy learning!
Cheers.