How are indices priced?
Indices can be classified by the method used to determine their price. We explain the different methods below:
The price of each component stock is the only factor that determines the value of the index. The total value of the index is calculated by adding together the share price of each stock in the index, then dividing the figure by the total number of stocks. Higher-priced stocks therefore carry more weight, exerting more influence on the performance of the index.
The Dow Jones Industrial Average is an example of a price-weighted index.
The price of each component stock is weighted depending on its market capitalisation, so larger companies hold a larger percentage weighting. The total value of the index is calculated by adding up the market caps of each stock and dividing them by the total number of stocks. This means that sectors containing very large companies, such as the mining and banking sectors, influence their national stock indices greatly.
The FTSE 100 Index is an example of a capitalisation-weighted index.
A number of equities, indices or other variables are grouped together and standardised, to provide a statistical measure of a market or sector’s overall performance over time. They provide a useful benchmark against which to measure an investor’s portfolio. Composite indices can be either price-weighted or capitalisation-weighted: the term ‘composite’ simply defines how the contents are sourced.
The NASDAQ Composite is an example of a composite index.
How do dividends affect index prices?
Dividend payments from the constituent shares of an index will generally cause the price of that index to fall. This is because the value of an individual share tends to drop on its ex-dividend date by the amount of the declared dividend.
If you have a futures position on an index, any expected dividend and interest payments will be factored into the price of the contract, so you won’t be affected by a drop in the index price.
If you have a long CFD position on an index that lists a company offering a dividend, you will also receive the dividend just as the company’s shareholders would. So, provided that you hold your long position at close of business on the day before the ex-dividend date, you shouldn’t find yourself adversely affected. The dividend payment you receive should counter-balance any loss caused by the drop in the price of the index. If you have a short position open at that point, you will pay the dividend instead.