A New Growth Index with Options: Morgan Stanley's EGI

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Yep, another index. But this one may actually be worthwhile.

As small-caps and their emerging growth cousins start to rack up impressive gains and steal the spotlight from the

S&P 500

and other large-caps,

Morgan Stanley Dean Witter

and the

Pacific Exchange

(PCX) are rolling out a new index options product for investors to capitalize on the sector.

Beginning today, the PCX will begin trading the

Morgan Stanley Emerging Growth Company Index

(EGI:PCX), an index of 50 highflying, death-defying equities from the technology, health-care and telecommunications industries.

While the EGI contracts are being targeted at institutional investors (and because the high volatility breeds pricey premiums), investors will be able to gauge market sentiment on the emerging growth sector's movement. Pundits are watching for a fourth-quarter rally while expressing a certain reticence about what happens next year. Investors have caught on to at least half of that message, pouring almost $6 billion into aggressive growth mutual funds during the past four weeks, according to Morgan Stanley executives.

Using testimonials from its two well-known strategists,

Byron Wien

and

Peter Canelo

, Morgan Stanley introduced the EGI Tuesday in Manhattan. While offering a cautious approach to the market, Wien said a "bear market is lurking" and that stocks that are going to perform well are the "more creative stocks" akin to those in the EGI.

The index opened at 342.52 on Wednesday and early trading showed some volume in October 345 calls at 9 3/4 and in the October 320, 325 and 300 puts. That conflict in put/call volume reflects the recent struggles of technology sector components, which make up 60% of the index and account for nine of the top 10 holdings.

The initial list includes roller-coaster favorites such as

Iomega

(IOM)

,

Planet Hollywood

(PHL)

,

Ascend

(ASND) - Get Report

and

Bed Bath & Beyond

(BBBY) - Get Report

. Morgan Stanley equity derivative strategist Scott Slayton, who said the firm was guided towards component stocks with market capitalizations of less than $6 billion, expects to replace 10% to 15% of the index on each rebalancing. Morgan executives also warned that the index is not a "recommended list."

Naturally the index will have a high volatility rating. Slayton said he expected five-day rolling volatility to be at least 28%, compared with 13% to 14% on the S&P 500. That volatility level is only exceeded only by the

Philadelphia Stock Exchange Semiconductor Index

(SOX:PHLX). In terms of performance, Morgan Stanley's EGI has returned 16% this year, as opposed to 28% for the S&P 500 and 36% for the

Morgan Stanley High Tech Index

(MSH:AMEX).

The index has traded as high as 358 and the initial strike prices on it range from 320 to 360 with $5 intervals. Slayton said he expects the early trading range to be between 280 and 340. The contract size of the options is the value of the index multiplied by $100. So, if the index is trading at 320, one contract will cost $32,000. EGI contracts are European-style exercise, meaning they can be traded but not exercised before the expiration date.

EGI options are subject to the same 15% margin regulations as most options.

Strategist Slayton sees two basic ways to play the EGI, both spread trades. The bull spread, for example, plots buying the December 345 call and selling the December 395 calls, so the premium from the write covers some of the cost and risk of the buy. In this scenario, the investor is optimistic that the EGI would be on the way up but more than happy to bail if it hits a lofty 395 level.

If an investor was somewhat less optimistic about the EGI, Slayton sees buying, for instance, a December 340 put and selling a December 310 put, with the same basic strategy in place.

"Because of the high volatility," Slayton said, "these options are expensive." Like any spread trade strategy, the idea is to get some upside but cut the premium and somewhat hedge the risk by writing a further out-of-the-money position. Commission costs are the downside of the spread strategies for most investors because at least four trades would be executed.

Here's a list of the stocks in the EGI:

Altera

(ALTR) - Get Report

American Power Conversion

(APCC)

Apac Teleservices

(APAC)

Ascend

(ASND) - Get Report

Aspect Telecommunications

(ASPT)

Atmel

(ATML)

Bed Bath & Beyond

(BBBY) - Get Report

Bio-Technology General

(BGTC)

Blyth Industries

(BTH)

BMC Software

(BCMS)

Boston Technology

(BSN)

Cabletron Systems

(CS) - Get Report

Cambridge Technology Partners

(CATP)

Catalina Marketing

(POS)

CDW Computer Centers

(CDWC)

Ciena

(CIEN) - Get Report

Compuware

(CPWR)

Delta & Pine Land

(DLP)

Diamond Offshore Drilling

(DO) - Get Report

Dollar Tree Stores

(DLTR) - Get Report

Etec Systems

(ETEC)

Gentex

(GNTX) - Get Report

Health Management Associates

(HMA)

Iomega

(IOM)

Jabil Circuit

(JBIL)

Jones Medical Industries

(JMED)

Learning Tree International

(LTRE)

Linear Technology

(LLTC)

Maxim Integrated Products

(MXIM) - Get Report

McAfee Associates

(MCAF)

Mentor

(MNTR)

Micron Electronics

(MUEI)

Nautica Enterprises

(NAUT)

Novellus Systems

(NVLS)

PairGain Technologies

(PAIR)

Parametric Technology

(PMTC)

Paychex

(PAYX) - Get Report

Planet Hollywood

(PHL)

Reading & Bates

(RB)

Remedy

(RMDY)

Rexall Sundown

(RXSD)

Robert Half International

(RHI) - Get Report

Sterling Commerce

(SE) - Get Report

Synopsys

(SNPS) - Get Report

Telco Communications Group

(TCGX)

Titanium Metals

(TIMT)

Veritas Software

(VRTS) - Get Report

Viking Office Products

(VKNG)

Visio

(VSIO)

Xilinx

(XLNX) - Get Report