This Day On The Street
Continue to site right-arrow
ADVERTISEMENT
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here
Stocks Under $10 with 50-100% upside potential - 14 days FREE!

Indices With a Weight Problem

The nation's tabloids are more than eager to discuss the weight problems of Keira Knightley and Kirstie Alley, but do they discuss the problems and opportunities created by different indices' disparate weighting schemes?

The answer, sadly, is no.

Yet some very real trading opportunities are created by nothing more than the way indices are constructed.

The S&P 500 Index, the default benchmark for many institutions, is capitalization-weighted.

Each stock's weight in the index is based on its price multiplied by the number of shares outstanding, divided by the total market capitalization of all stocks in the index.

The Dow Jones Industrial Average, in contrast, is a price-weighted index. It is calculated by summing the prices of the 30 stocks in the index and dividing by a divisor, now .12493117, that reflects the impact of splits and stock dividends.

The more expensive a stock is, the greater its weight in the Dow Industrial Average.

The relative weights of the 30 Dow stocks in both indices are presented in the chart below.


Comparative Weights in Dow Industrials and S&P 500
Click here for larger image.
Source: Bloomberg

What is the impact of the different weighting schemes? The stocks with the highest and lowest prices in the Dow are Boeing (BA) and Intel (INTC), which closed on Friday at $79.99 and $18.56, respectively. If both stocks rise by $1 a share, they have an equal impact on the Dow. However, Intel accounts for 0.9426% of the S&P 500 and Boeing 0.5584%, meaning its impact will be 1.69 times as large.

If one of the Dow stocks has a big move higher or lower, as 3M (MMM) did Friday or Altria (MO) Thursday, the disparate impact on the indices is noticeable. The $7.29 drop in 3M accounted for 58.4 points of the Dow's loss of 134.63 points, or 43.38% of the index's move. On the same day, 3M accounted for 0.607 points of the S&P 500's 8.60 point loss, or 7.06%.

The Embedded Option

The systematic impact of differential weighting over time should lead to a higher actual volatility for the Dow, and it does. Its standard deviation of returns since August 1974 has been 1.021725 times as great as that of the S&P 500; we will use this number in a trade illustration below. And even though the indices track each other remarkably well over long periods of time, considering their significant differences, they should not be viewed as substitutes for one another on a daily basis. If they were, we should expect both the regression coefficient and the r-squared to be far closer to one than the .855 and .7639 shown.




Indices Are Not Substitutes
Click here for larger image.
Source: Bloomberg

If the S&P 500's historic volatility is systematically lower than the Dow's historic volatility, can we capture this by owning a Dow strangle --­ long an out-of-the-money (OTM) call option and an OTM put option -- against a short S&P 500 straddle, short both the at-the-money (ATM) call and put options?

1 of 2

Select the service that is right for you!

COMPARE ALL SERVICES
Action Alerts PLUS
Try it NOW

Jim Cramer and Stephanie Link actively manage a real portfolio and reveal their money management tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
  • Weekly roundups
TheStreet Quant Ratings
Try it NOW
Only $49.95/yr

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
  • Upgrade/downgrade alerts
Stocks Under $10
Try it NOW

David Peltier, uncovers low dollar stocks with extraordinary upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
  • Weekly roundups
Dividend Stock Advisor
Try it NOW

Jim Cramer's protege, David Peltier, identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Alerts when market news affect the portfolio
  • Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
Real Money Pro
Try it NOW

All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.

Product Features:
  • Real Money + Doug Kass Plus 15 more Wall Street Pros
  • Intraday commentary & news
  • Ultra-actionable trading ideas
Options Profits
Try it NOW

Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • 100+ monthly options trading ideas
  • Actionable options commentary & news
  • Real-time trading community
  • Options TV
To begin commenting right away, you can log in below using your Disqus, Facebook, Twitter, OpenID or Yahoo login credentials. Alternatively, you can post a comment as a "guest" just by entering an email address. Your use of the commenting tool is subject to multiple terms of service/use and privacy policies - see here for more details.
Submit an article to us!

Markets

DOW 18,030.21 +6.04 0.03%
S&P 500 2,081.88 -0.29 -0.01%
NASDAQ 4,773.4720 +8.0480 0.17%

Brokerage Partners

Rates from Bankrate.com

  • Mortgage
  • Credit Cards
  • Auto

Free Newsletters from TheStreet

My Subscriptions:

After the Bell

Before the Bell

Booyah! Newsletter

Midday Bell

TheStreet Top 10 Stories

Winners & Losers

Register for Newsletters
Top Rated Stocks Top Rated Funds Top Rated ETFs