If you like economics and are fascinated by news from the financial world, trading index options might be right for you. There are few things in life more rewarding than taking a position in S&P 500 Index (.SPX) options and then banking a profit after the market makes a sudden move higher or lower. Before venturing into the world of index options trading, however, it's important to understand the product. Not only do we need to understand how the options are settled, but also know the ins and outs of the index itself.

An important difference between stock options and index options is that equity options settle for shares. If a contract is exercised or assigned, 100 shares of stock is transferred from one investor to another. However, cash indexes like the S&P 500 Index, the NASDAQ 100 Index (.NDX), and S&P 100 Index (.OEX) have no shares. They are proxies for market action. Therefore, the exercise or assignment of an options contract involves the transfer of cash (Please see another article titled Know Your Options in the Index Market for more details on the settlement of index options.) Understanding how index options settle is an important first step before trading puts and ca lls in the index market.

While it's important to understand that index options settle for cash rather than shares, it also makes sense to take a look at how the index is constructed as well. Not all are created alike and the methodology used to compute the index will have an important impact on the day-to-day price swings. The number of components within the index will also affect its overall levels of volatility. All else being equal, the greater the number of constituents in the index, the greater the diversity and the lower the levels of volatility.

For example, the S&P 500 Index is a popular product among options and futures traders. As the name suggests, the index consists of five hundred companies selected by a committee at Standard & Poor's selects. Companies are selected for inclusion in the index based on several factors including market value, liquidity, and industry or sector. The index is considered the quintessential benchmark for the performance of the overall market, and also has among the most actively traded options and futures contracts.

Like many popular indexes today, the S&P 500 is market-value weighted. Using this methodology, the companies with the largest market capitalizations (shares outstanding X market price) will have the largest weighting within the index. The weighting is determined by taking the market value of the company divided by the current market value of all companies within the index. As we can see from the table below, the top 20 components, which represent only 4 percent of the total number of companies, account for more than 30 percent of the market cap of the total index. The NASDAQ 100 and the S&P 100 are also market value-weighted and, like the SPX, large companies dominate their performance.

While the S&P 500 is market-value weighted, the Dow Jones Industrial Average is an index of thirty companies computed using a price-weighted methodology. A committee at Dow Jones selects companies for the industrial average that are considered among leaders in their respective industries and have among the most actively traded shares. "Using such large, frequently traded stocks provides an important feature of the Industrial Average: timeliness. At any moment during the trading day, the price of the Dow Jones Industrial Average is based on very recent transactions," according to Dow Jones.

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The industrial average is computed using a methodology that favors higher priced stocks. For example, IBM (IBM), which now trades for more than $190 per share, accounts for about 11.5% the overall value of the Dow. Meanwhile, BofA's (BAC) trades for under $6 and its weighting in the industrial average has declined to less than 0.5%. So when trading options on the Dow averages, like Dow Jones Industrial Index (.DJX), or other price-weighted indexes, it is important to keep in mind that high-priced stocks will have a greater influence on the overall performance of the index.

A third less-common method used to compute an index is the equal-dollar method. Some of the sector indexes, like the NYSE ARCA Airline Index (.XAL) and the AMEX Biotechnology Index (.BTK), are created so that each component within the index has an equal impact on performance - regardless of market value or price.

Bloomberg ran an interesting story today about the performance of the S&P 500 over the past ten years. It noted that, while the S&P 500 is down 19% since 2000, the index is up 66% during that time if you strip out the performance of the biggest companies like Exxon Mobil (XOM), Cisco (CSCO) and General Electric (GE). In other words, an equal-weighted S&P 500 Index like the one used to compute the Rydex Equal-Weighted ETF (RSP), has performed well over the past ten years. The poor performance of large companies is the main reason for the S&P 500's losses in the past decade. In short, it pays to understand the make-up of the index when looking at long-term and short-term trends. If you're not sure where to find the methodology used to compute an index, look at the product specifications page on one of the exchanges like cboe.com, at the Standard and Poor's web site (standardandpoors.com), or dowjones.com.

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At the time of publication, Fred Ruffy held no positions in the stocks or issues mentioned.