Market indices are influenced by a variety of factors, not just the overall economic health or performance of the industries they track. Understanding what drives an index’s price is crucial for traders looking to navigate the market effectively. While it’s exciting to follow top-performing companies, it’s essential to recognize the broader forces that can cause an index’s price to shift.

An index’s value can change due to a combination of the following factors:

  • Political and National Events: Major political events—such as wars, trade deals, or shifts in government policies—can destabilize or shift indices. For example, the Hang Seng Index, which includes companies like Alibaba, was negatively impacted by China’s regulatory crackdown on its tech sector in 2021. Similarly, global events like the Omicron variant of COVID-19 caused market-wide declines in indices such as the S&P 500 and the Dow Jones.
  • Company Performance: Changes within the companies that make up an index can directly affect its value. For instance, during the Delta variant’s spread in 2021, Moderna’s stock surged by 434%, significantly impacting the S&P 500. Positive earnings or corporate news can cause an index to move up, while company missteps or negative reports can pull it down.
  • Economic Data: Key economic indicators such as inflation rates, unemployment figures, interest rates, and earnings reports can have a considerable effect on indices. An example is Federal Reserve Chairman Jerome Powell’s statement in November 2021, which initially led to declines in indices like the S&P 500, before a later rebound. Similarly, the Nikkei 225 (Japan 225) fell in September 2021 due to rising inflation concerns.
  • Market Sentiment: Market sentiment, or the overall mood of investors, can significantly impact indices. If investors believe a market is headed for a downturn, it can create a “bearish” sentiment, leading to broad sell-offs. In December 2021, the downturn in cryptocurrency markets, driven by negative trader sentiment, also affected indices like the Crypto 10.

How an Index Is Constructed

As noted, an index is composed of multiple companies, and any changes in the performance of these companies will inevitably influence the index’s overall value. The process of building an index is designed to capture the most representative companies within a specific sector or market.

Take, for example, the FTSE 100 index, which tracks the 100 largest companies on the London Stock Exchange. In 1984, the Financial Times Stock Exchange (FTSE) began analyzing the financial reports and market capitalization of companies traded on the LSE. After evaluating their market cap and performance, they selected the top 100 companies for inclusion. Every quarter, FTSE reviews company reports to ensure that the list remains accurate and reflects the most valuable companies.

PFD Markets provides traders with the option to trade CFDs on various indices, allowing for speculation on the movements of these market benchmarks.

How an Index’s Value Is Calculated

Calculating an index’s value can be complex. The FTSE 100, for example, aggregates the market capitalization of the top 100 companies on the LSE. However, to break this down into a more understandable number, two common valuation methods are employed:

Float-Adjusted Market Capitalization

In the case of the FTSE 100, the value of a company isn’t determined solely by its total share count but by the number of shares available for trade on the open market. For instance, if a company has 1,000 shares but only 850 are freely tradable, the market cap calculation is based on the 850 shares. The formula for calculating free float market cap is:

(Total Shares – Locked Shares) x Share Price = Free Float Value

Once the free float value is calculated for each company in the index, the overall value of the index is computed and updated regularly. For example, when the value of these companies rises, so does the FTSE 100 index.

Price-Weighted Valuation

Another method used in index valuation is price-weighted, which focuses on the individual share price of the constituent companies. This method was pioneered by Charles Dow and Edward Jones in 1885 to create the Dow Jones Industrial Average (DJIA). In this system, each company in the index is given equal weight based on its share price, regardless of its overall market capitalization. The index value is then determined by averaging the share prices, adjusted by a divisor.

For example:

Total Share Prices of Companies / Divisor = Index Value

This price-weighted method is used by indices like the DJIA, Nasdaq Composite, and S&P 500. However, critics argue that this approach doesn’t account for stock splits or new share issuances, potentially distorting the index value.

PFD Markets allows traders to open CFD positions based on the price movements of indices, utilizing these valuation methods to help guide investment strategies.

Understanding Index Fluctuations

Once you understand the calculation methods, it’s important to recognize how market events influence an index’s fluctuations. For instance, major geopolitical events, natural disasters, or the emergence of new economic data can trigger volatility. During a crisis, such as the outbreak of COVID-19, investors may rush to sell their holdings, fearing that companies will struggle and investments will lose value. This can lead to a sharp drop in index values.

On the flip side, good news—such as positive earnings reports, trade agreements, or new technological advancements—can lead to a surge in stock prices, pushing an index upward. The supply and demand for shares plays a critical role in this process: as demand increases for a stock, its price rises, which in turn drives the index higher.

However, it’s important to remember that indices represent a collection of stocks. As some companies rise in value, others may fall. The result is a balance that can either push the index up or pull it down, depending on the combined performance of all its constituents.