Advantages to Trading Index Options
So in trading index options in place of individual stock options, you achieve effective diversification of risk. In fact, the risk of individual stock options is replaced by a market-wide risk based on the structure of the index. For many traders, this is viewed as an advantage and perhaps as the only way to truly diversify an options trading portfolio.
If you were to attempt to approximate the movement of even a limited index such as the DJIA, you would still need to trade options in all of the 30 companies it lists. This is not practical for most traders and, in fact, would not necessarily be as effective as it is to trade in the options using the DJIA as the underlying security.
The specific price movement of an option will vary based on how the index is calculated and on how broadly the index represents the larger market. A broad-based index includes a larger number of components in many different market sectors. For example, the Nasdaq Composite Index includes all of the stocks listed on the exchange.
In comparison, a narrow-based index is limited to a smaller number of issues. For example, the Dow Jones Industrials includes the stocks of only 30 large so-called "industrial" companies. Even so, the DJIA represents nearly half of the total value of all U.S. companies listed and traded on the public exchanges.
Another very important distinction is the method used to calculate the numerical value of an index. Some indices are capitalization weighted, also called a market value-weighted index, including the Nasdaq Composite, S&P 500, and Wilshire 5000 indices.
Another group of indices are price weighted, which means the market value is used to calculate the index value. These are weighted for not only changing market value per share, but also for stock splits. So the divisor is continually changing for each of the components in a price-weighted index.
A simplified method for creating an index involves adding together the total prices of all components and dividing the result by the number of securities. This method becomes inaccurate, however, whenever there is a stock split; so, over time, the non-weighted approach will become increasingly inaccurate.
Index components change periodically due to merger and acquisition activity, or because a particular company becomes less representative of the index itself, at least in the opinion of the publisher of the index. For example, the Dow Jones Company publishes numerous indices but does not announce how it determines whether a particular company should be dropped and replaced. An index is intended to accurately report movement in the broader market, so that investors and traders will be able to track markets and make sound judgments about current market conditions; so as long as an index accurately reflects these current conditions, it continues to have validity for traders. And options that are traded on these indices allow you to trade the overall market with a realistic expectation that the index will, in fact, move in line with market conditions.
By Michael C. Thomsett