Index Options - Part 2
What is an Index?
A stock index is a compilation of several stock prices into a single number. Investment indexes come in various shapes and sizes. Some are broad-based and measure moves in broad, diverse markets. Others are narrow-based and measure more specific industry sectors of the marketplace. Understand that it is not the number of stocks that comprise the average that determine if an index is broad-based or narrow-based, but rather the diversity of the underlying securities and their market coverage. Different stock indexes can be calculated in different ways. Accordingly, even where indexes are based on identical securities, they may measure the relevant market differently because of differences in methods of calculation.
An index can be constructed so that weightings are biased toward the securities of larger companies, a method of calculation known as capitalization-weighted. In calculating the index value, the market price of each component security is multiplied by the number of shares outstanding. This will allow a security's size and capitalization to have a greater impact on the value of the index.
Another type of index is known as equal dollar-weighted and assumes an equal number of shares of each component stock. This index is calculated by establishing an aggregate market value for every component security of the index and then determining the number of shares of each security by dividing this aggregate market value by the current market price of the security. This method of calculation does not give more weight to price changes of the more highly capitalized component securities.
In addition to those mentioned above, there are two other types of index traded funds that exist. An index can also be a simple average—it is calculated by simply adding up the prices of the securities in the index and dividing by the number of securities, disregarding numbers of shares outstanding. Another type measures daily percentage movements of prices by averaging the percentage price changes of all securities included in the index.
Adjustments & Accuracy
Securities may be dropped from an index because of events such as mergers and liquidations or because a particular security is no longer thought to be representative of the types of stocks constituting the index. Securities may also be added to an index from time to time. Adjustments to indexes might be made because of such substitutions or due to the issuance of new stock by a component security. Such adjustments and other similar changes are within the discretion of the publisher of the index and will not ordinarily cause any adjustment in the terms of outstanding index options. However, an adjustment panel has authority to make adjustments if the publisher of the underlying index makes a change in the index's composition or method of calculation that, in the panel's determination, may cause significant discontinuity in the index level.
Finally, an equity index will be accurate only to the extent that:
- the component securities in the index are being traded
- the prices of these securities are being promptly reported
- the market prices of these securities, as measured by the index, reflect price movements in the relevant markets.
Read more about index options in Part 3 of this guide. To get started trading index funds, open your account at Firstrade today!
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