Selection criteria of Index for trading
The sub‑topic 6.3 focuses on the selection criteria of an index for trading equity derivatives. It explains what makes an index eligible, the regulatory backdrop, and the practical checks a distributor must perform. Mastering this helps you answer exam questions on index eligibility and product design. It also links directly to the broader Trading Mechanism chapter of the NISM Series VIII certification.
Learning Objectives
- 1Define an index and its role in equity derivatives.
- 2Identify the SEBI and NISM regulatory requirements for index selection.
- 3Explain the quantitative and qualitative criteria used to evaluate an index.
- 4Apply the index calculation formula and assess liquidity considerations.
What is an Index?
An index is a statistical measure that reflects the performance of a selected group of securities, typically representing a market segment or the entire market.
In equity derivatives, the index serves as the underlying asset for index futures and options, providing a transparent and standardized benchmark that traders can hedge or speculate on.
For the NISM exam, understanding the nature of an index is essential because questions often ask which indices are eligible for derivative contracts and why certain indices are excluded.
- Indices are calculated in real‑time, enabling continuous price discovery.
- They must be based on securities listed on recognised Indian exchanges.
Regulatory Framework for Index Selection
SEBI’s Regulation 9 of the Securities Contracts (Derivatives) Regulations, 2021 mandates that the underlying index for any derivative contract must be approved by the Exchange and must comply with SEBI’s guidelines on transparency and methodology.
The NISM syllabus reiterates that an index must be published by a recognised index provider, such as NSE or BSE, and must be reviewed periodically to ensure that the constituent securities continue to meet eligibility norms.
Exam‑takers often confuse the term “any market index” with “SEBI‑approved index”. Remember that only indices that satisfy the regulatory checklist can be used for listed futures and options.
Do not assume that a popular index like the NIFTY 100 is automatically eligible for all derivative products. The exam may ask you to verify SEBI approval and the specific eligibility criteria for the product you are designing.
Key Selection Criteria
The first criterion is representativeness – the index should capture the economic or sectoral segment it claims to represent. This is achieved by selecting securities that together account for a substantial portion of the market‑capitalisation of that segment.
Second, the index must be transparent. The methodology, weighting scheme, and rebalancing schedule must be publicly disclosed, allowing participants to anticipate changes and calculate fair values.
Third, liquidity is vital. The constituent securities should have high average daily turnover and low bid‑ask spreads, ensuring that the index can be replicated without excessive transaction costs.
Finally, regulatory compliance is non‑negotiable. The index must be approved by the Exchange, adhere to SEBI’s definition of a tradable underlying, and be reviewed at least annually for constituent changes.
Selection Criteria and Their Practical Implications
| Criterion | What to Check | Exam Focus |
|---|---|---|
| Representativeness | Coverage of market‑cap or sectoral weight > 70% | Identify if index truly reflects the intended market |
| Transparency | Publicly available methodology and divisor | Remember that hidden formulas lead to disqualification |
| Liquidity | Average daily turnover > ₹500 crore and bid‑ask spread < 0.5% | Liquidity thresholds are frequently asked |
| Regulatory Approval | SEBI‑approved and Exchange listed | Only SEBI‑approved indices can be underlying |
Index Construction Methodology
Indices are built using one of three common weighting schemes: price‑weighted, market‑cap weighted, and free‑float market‑cap weighted. Price‑weighted indices give higher influence to high‑price stocks, while market‑cap weighted indices allocate weight based on total market value.
In Indian practice, most major indices such as NIFTY 50 and SENSEX use free‑float market‑cap weighting. This adjusts the weight of each stock to the portion of shares that are actually tradable, removing the impact of promoter holdings.
The calculation uses a divisor to keep the index level stable despite corporate actions like stock splits or dividends. Understanding the divisor concept is crucial for exam questions that involve index level adjustments.
Where:
P_{i}= Market price of the i^{th} constituent stock in rupeesQ_{i}= Number of shares (or free‑float factor) used for weighting of the i^{th} stockD= Divisor – a constant chosen by the index provider to maintain continuityWorked Example
Given three stocks: Stock A: P=100, Q=10 Stock B: P=200, Q=5 Stock C: P=300, Q=2 Divisor D=1 Step 1: Compute numerator = (100×10)+(200×5)+(300×2)=1000+1000+600=2600 Step 2: Index = 2600 ÷ 1 = 2600 Verification: \frac{(100\times10)+(200\times5)+(300\times2)}{1}=2600
Liquidity and Tradability Requirements
Liquidity is assessed at both the index level and the constituent level. The Exchange looks for an average daily turnover of the basket that exceeds a predefined threshold, often quoted in crore rupees.
Each constituent must also meet a minimum free‑float market‑cap and a bid‑ask spread limit. Low‑liquidity stocks can cause tracking error for futures and options, leading to higher margin requirements.
From an exam perspective, remember that the SEBI guideline cites a minimum turnover of ₹500 crore for an index to be considered for derivative contracts. Questions may present turnover figures and ask you to decide eligibility.
Average Daily Turnover (₹ crore) of Candidate Indices
When the question provides turnover numbers, compare them against the ₹500 crore benchmark. Only indices above this level satisfy the liquidity criterion for futures and options.
Scenario
An Indian brokerage wants to launch a futures contract on a sectoral index. The three shortlisted indices have the following characteristics: (i) Index A – free‑float market‑cap weighted, turnover ₹620 crore, 30 constituents; (ii) Index B – price‑weighted, turnover ₹480 crore, 25 constituents; (iii) Index C – free‑float market‑cap weighted, turnover ₹720 crore, 28 constituents.
Solution
Step 1: Verify SEBI approval – assume all three are SEBI‑approved. Step 2: Apply the liquidity rule – Index B fails because its turnover is below the ₹500 crore threshold. Step 3: Check representativeness – all have >25 constituents, satisfying the minimum number requirement. Step 4: Evaluate transparency – price‑weighted Index B uses a simple formula but is less preferred in Indian markets; Index A and C use free‑float market‑cap weighting, which is the standard. Therefore, Index C is the best choice as it meets liquidity, representativeness, and uses the preferred methodology.
Conclusion
The brokerage should select Index C. The exam often tests the sequential filtering approach – liquidity first, then methodology and representativeness.
⭐Exam Takeaways
- An index must be SEBI‑approved, transparent, and represent the intended market segment to be used as an underlying for equity derivatives.
- Key quantitative criteria include minimum average daily turnover (₹500 crore) and a minimum number of constituents (usually ≥25).
- Free‑float market‑cap weighting is the preferred methodology for Indian indices; price‑weighted indices are rarely accepted for futures and options.
- The index value is calculated as the weighted sum of constituent prices divided by a divisor; the divisor keeps the index level stable after corporate actions.
- Liquidity is assessed both at the basket level and at the individual stock level – low‑liquidity constituents can cause tracking error and higher margin requirements.
- When faced with multiple candidate indices, apply the checklist in order: regulatory approval → liquidity → representativeness → weighting methodology.
- Common exam mistake: assuming any well‑known index (e.g., NIFTY 100) is automatically eligible without checking SEBI’s specific criteria.
Practice Questions
8 questions on Selection criteria of Index for trading
What is an index in the context of equity derivatives?
What is the minimum average daily turnover required for an index to be eligible for futures and options contracts?
An index has an average daily turnover of ₹480 crore, 30 constituents, and is SEBI‑approved. Which selection criterion does it fail?
Which weighting scheme is most commonly used by major Indian indices such as NIFTY 50 and SENSEX?
A candidate index has turnover ₹620 crore, 28 constituents, free‑float market‑cap weighting, and is SEBI‑approved. According to the checklist, is this index eligible for a new futures contract?
When evaluating candidate indices for a derivative product, which step should be performed first according to the recommended checklist?
Three SEBI‑approved indices are considered: Index A – free‑float market‑cap weighted, turnover ₹620 crore, 30 constituents; Index B – price‑weighted, turnover ₹480 crore, 25 constituents; Index C – free‑float market‑cap weighted, turnover ₹720 crore, 28 constituents. Which index should be selected for a new futures contract?
Which statement about the divisor used in index value calculation is correct?