I'm looking to create a custom index. Basically a sector index of stocks that I choose. What would be the best or most accurate way to do that type of index from the standpoint of component weighting? No weighting: I could have each component in the index have equal value. Market Cap weighting: The weighting of a stock would be as a percent of the market cap of that stock to the total of the market cap of all stocks in my custom index. Volume traded weighting: The weighting of a stock would be as a percent of the avg number of shares traded on a daily basis of that stock to the total avg number of shares traded on a daily basis of all stocks in my custom index. This could be re-calced daily to give more weighting to stocks that pick up in activity. Avg Value traded weighting: The weighting of a stock would be as a percent of the avg value traded (as calculated by avg daily shares * most recent closing price) on a daily basis of that stock to the total avg value traded on a daily basis of all stocks in my custom index. This could be re-calced daily to give more weighting to stocks that pick up in activity. This is what I've thought of so far. Which of these sould most representative of an index? Or does someone have a better way for a custom index. My calculations would be done in Excel or something similar. Cash
For trading purposes... Unweighted sector indexes of minimun 10 stocks are superior... Because you want don't want the index skewed by a large cap stock XYZ. Also... For the sector index you should screen and use... ONLY the stocks with the highest corelation to their universe/sector. If you primarily trade XYZ... Then you might leave it out of the index entirely... In order to see what the sector less XYZ is doing.
Hmm, that's kind of a circular reference. How do I get an index of the sector to correlate it to? Cash
Oversimplified Example - Universe With 10 Stocks (1) Go back 6-12 months... whatever you choose. (2) Preliminary Universe Index = Unweighted Average of all 10 stocks (If they are not all close in price... normalize them so each has same weight). (3) Calculate corelation to Preliminary Index of all 10 stocks... and rank 1 to 10. (4) Use the Top 5 (or whatever)... with highest corelation to calc Final Universe Index. This can be optimized many, many different ways... Depending on what you are trading. It's not circular... but can be viewed as pseudo-recursive.
I'd say it's horses for courses. Whats the purpose of the index? Use Market Capitalisation if you want to know how the biggest companies are floating in your particular sector/stock list. Use equal weighting if you plan to trade an equal amount of money on each trade. Use Liquidity if you're trading so big that you have to vary your size while trading each symbol. etc. That way you learn what you want to know based on what you want to do. Even better might be to use a combination, for example how does the liquidity index compare to the equal weighting index (of the same symbols)? It might tell you if big or small stocks are favoured, or differ in volatility etc.