Index Options: Understanding The Underlying
...Continued from "Introduction"
What is an Index?
A stock index is a compilation of several stock prices into a singlenumber. Indexes come in various shapes and sizes. Some are broad-basedand measure moves in broad, diverse markets. Others are narrow-basedand measure more specific industry sectors of the marketplace.
Understand that it is not the number of stocks that comprise theaverage that determine if an index is broad-based or narrow-based, butrather the diversity of the underlying securities and their marketcoverage.
Different stock indexes can be calculated in different ways.Accordingly, even where indexes are based on identical securities, theymay measure the relevant market differently because of differences inmethods of calculation.
An index can be constructed so that weightings are biased toward thesecurities of larger companies, a method of calculation known ascapitalization-weighted.
In calculating the index value, the marketprice of each component security is multiplied by the number of sharesoutstanding. This will allow a security's size and capitalization tohave a greater impact on the value of the index.
Another type of index is known as equal dollar-weighted and assumes anequal number of shares of each component stock. This index iscalculated by establishing an aggregate market value for everycomponent security of the index and then determining the number ofshares of each security by dividing this aggregate market value by thecurrent market price of the security.
This method of calculation does not give more weight to price changes of the more highly capitalized component securities.
An index can also be a simple average: calculated by simply adding upthe prices of the securities in the index and dividing by the number ofsecurities, disregarding numbers of shares outstanding.
Another typemeasures daily percentage movements of prices by averaging thepercentage price changes of all securities included in the index.
Adjustments & Accuracy
Securities may be dropped from an index because of events such asmergers and liquidations or because a particular security is no longerthought to be representative of the types of stocks constituting theindex. Securities may also be added to an index from time to time.
Adjustments to indexes might be made because of such substitutions ordue to the issuance of new stock by a component security. Suchadjustments and other similar changes are within the discretion of thepublisher of the index and will not ordinarily cause any adjustment inthe terms of outstanding index options.
However, an adjustment panel has authority to make adjustments if thepublisher of the underlying index makes a change in the index'scomposition or method of calculation that, in the panel'sdetermination, 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.
Continued in "Index Options: Pricing, Volatility & Risk"...
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