Stock Option Basics
THE COMPILATION OF INDICES
By FRANK KNEIPHER
Mar 6, 2007 - 5:47:00 PM

An index provides a measure of the value of a group of stocks.

Indices are used extensively to measure change and volatility in areas of economic interest such as currencies, the cost of living, or unemployment. Stock indices are typically compiled by firms affiliated with the securities industry (e.g., Standard & Poor's, Value Line, Dow Jones) or exchanges, and are generally developed to mirror the broad market, a foreign market, or specific industries.  An index is monitored or benchmarked against the value at which it was initially set. An index will reflect the market or particular industry only to the extent that the underlying issues are representative of the broad market or a specific industry. The base market divisor, an element in the calculation of the index, may be adjusted periodically as the companies that comprise the index merge, issue additional stock, or are removed because they no longer reflect the particular group. Changes in the base market divisor will not affect the options on an index or its value.

The values of the indices on which options are traded are updated and disseminated continuously throughout the trading day. Investors can obtain real-time values from a broker or through any of the on-line quote systems. Investors interested in the daily high, low, and closing values can find this information in most major daily newspapers or via the Internet.

How Indices are Weighted

Indices are typically calculated as capitalization-weighted, modified-capitalization-weighted, price-weighted, or equal-dollar-weighted. In a capitalization-weighted (value-weighted) index, the market price of each issue is multiplied by the number of outstanding shares in that issue; the total market capitalization is then divided by the base market divisor to arrive at the index value. In a capitalization-weighted index, the more highly capitalized issues are weighted more heavily than the less capitalized ones, and changes in the stock price of highly capitalized issues have a greater impact on an index's value.

Modified-capitalization-weighted indices are intended to maintain as closely as possible the proportional capitalization distribution of a portfolio of stocks, while limiting the maximum weight for a single stock or group of stocks to a predetermined maximum (normally 25% for a single stock and 50% to 60% for the top 5 or an aggregation of all stocks weighing 5% or more). This rebalancing is accomplished by occasionally artificially reducing the capitalization of higher-weighted stocks and redistributing the weight to lower weighted stocks. The net result is a weight distribution that is less skewed toward the larger stocks, but still does not approach equal weighting. The total capitalization of the portfolio remains the same.

Price-weighted indices are calculated by adding the prices of the component stocks and dividing by the base market divisor, without any regard to capitalization. Typically, the higher priced and more volatile constituent issues will exert a greater influence over the movement of a price-weighted index.

Equal-dollar-weighted indices assign equivalent influence to each component stock by representing them in approximate equal-dollar amounts. These indices are rebalanced once per quarter to ensure that the components continue to have equal influence. 

Frank Kneipher

FKPRINTS1@YAHOO.COM