What moves the Index? - The concept of 'Information Flow' and how it works in ^NIFTY50
We’ve all wondered at some point or the other as to what moves the Index?
And if you are an avid Fintwit follower, you would also have heard people saying “The futures are at a discount, looks like market will fall” or “I see some big orders being punched in NIFTY FUTs, the index is going to rocket”, and other similar things.
In this post, Let’s try to deconstruct how an index moves from one point to another.
So let’s start with the basics
What is an Index? - An Index is a collection of Stocks, the prices of which are weighted and together they arrive at an aggregate value. The weightage in case of ^NIFTY50 Index is based on the market cap of the constituent stocks. If you want to learn more about the constituent stocks and their weight-age, this is the place.
So how do we trade or speculate on an Index? - There are two broad ways to speculate on an Index, and that’s is either through Index Futures or Index Options. For Investors though the choices are ETFs and Index Mutual Funds.
For the context of this post we will stick with Index Futures. In our case that would be NIFTY FUT.
What makes the Index move up or down? - Say the average change in the value of an index is 30 points, why does it move so much?
Average change here means the average of the Open-Close value of the index.
For example if the index opened at 11050 today and closed at 12000 we had a change of +50 points. So if we average this value over say 20 trading days, we may arrive at a value something close to 30. So what’s making this move happen?
It moves because the prices of the constituent stocks change. Say for instance if the top 5 stocks, by market cap - Reliance, HDFC, HDFC Bank, ITC, Infy etc. move down, the market will move down, and visa versa. However, there could be other factors which can effect the change as well, for example, in very short time frames like under 5 minutes, in certain indexes, its the Futures which leads the change in the Index value.
Time-frame of analysis and how it can make a difference?
Are we looking at reasons as to why index moved since last week? or are we looking at reasons as to why index moved since last minute?
As you can see, if you are looking at change on larger time frames, its always Constituents Stocks leading the change in Index value, however on shorter time frames it could be Futures leading the change in Index value.
What is “Information Flow” and what is its relevance here?
Information flow is about the direction of causality of price discovery in a given market, due to the flow-of-information (news/announcements etc.) If that sounds a bit wonkish - what it means is, its either the traders of the constituents stocks who react to the news flow first or its the Index Futures traders who do. These two types of reactions cause two different types of Information flows across Indexes (Spot) and Futures.
The two types of informational flows
Type - a) (Stocks) Spot to Index Futures : Spot value changes first leading the Futures prices to change
Type - b) Index Futures to (Stocks) Spot : Futures prices change first leading the change in the Spot value
Like everything else, it’s more about which type of information flow is more dominant in a given market. It’s not necessarily binary.
As pointed out in the research paper below, for ^NIFTY50 its Type (a) which is more dominant (Image below from reference #2).
This however is not true for all markets, for instance the S&P 500 works on Type (b) logic.
Excerpted from - Sehgal, S., Dutt, M. Domestic and international information linkages between NSE Nifty spot and futures markets: an empirical study for India. Decision 43, 239–258 (2016). https://doi.org/10.1007/s40622-016-0137-1
So if you are a short term / intraday trader in ^NIFTY it may be of more value for you to know that its the Spot that leads the Futures.
And one more thing
How do the quants/researchers know, which of the two moves first - Index Value (Spot) vs. Index Futures?
There are different statistical ways of measuring the strength and direction of causality, look up “tests of causality” if you are interested, for further reading, look up Judea Pearl’s work.
As an Intraday trader, the next time you think about - Why did the ^NIFTY50 index move? You might ask well ask - Which of the constituent stocks moved ^NIFTY50?
Trivia
The name NIFTY50 actually comes from the US Markets, more here.
Judea Pearl happens to be Daniel Pearl’s father