An Index is created by selecting stocks that are representative of the entire market or a specific sector of the market. For example the Nifty tracks the movement of 50 blue-chip companies listed in the National Stock Exchange (NSE). Similarly, the Sensex tracks the movement of 30 blue-chip companies listed in the Bombay Stock Exchange (BSE).
While the Sensex and Nifty are broad-market index (representative of the entire market), an example of a sectoral index is the Nifty Bank Index which is an index comprised of the twelve most liquid and large capitalised Indian Banking stocks.
A stock market index indicates the overall market (or sector) movement by tracking the changes in market capitalisation of stocks that represent the index. A company's Market Capitalisation is arrived at by multiplying the total outstanding shares of a company by its current market price.
If a company's market price moves up so will its market capitalization.
Thus, when you hear that the Sensex or the Nifty has moved up by 1 percentage point, it generally indicates that the overall market movement (as reflected by the stocks constituting the index) has been positive.
A Fun Read: Create Your Custom Stock Market Index.
Note that generally, a share market index measures the changes in Free-Float market capitalization of its constituent stocks.
As per BSE, Free-float market capitalization takes into consideration only those shares issued by the company that are readily available for trading in the market. It generally excludes promoters' holding, government holding, strategic holding and other locked-in shares that will not come to the market for trading in the normal course. In other words, the market capitalization of each company in a Free-float index is reduced to the extent of its readily available shares in the market.