Trading index options | How to trade options

You've heard about them in the news, you've heard they're easy to trade, they tell you what to do with your investments, but what exactly are index products? First, let's define an index. Simply put, an index represents a "basket" or portfolio of stocks or commodities, grouped in a particular way. For example, the S&P 500 Index is made up of large-capitalization stocks, while the Russell 2000® Index is based on small-capitalization stocks. How a particular stock or commodity index tracks the market depends on its composition - the stocks or commodities included in the index, the percentage weight of each component, and the method of calculating each index. The index comprising these stocks or commodities is typically called the "underlying" or "cash" index.

Trading index futures enables you to participate in broad market moves with one trading decision, without having to select individual issues. Stock index futures and options contracts closely follow the price movement of their respective underlying indexes. These products are widely used by financial professionals as well as individual investors, for portfolio protection as well as investment reward.

Even those who think they're not involved in the markets usually are. Think of your IRA or 401(k) plan. There's a good chance that a significant percentage of your retirement fund is invested in equities. People generally are aware of major stock market moves, but few have the time or the expertise to follow the movement of individual stocks and take appropriate action. So, they read The Wall Street Journal, watch the financial channels, or check out the Internet for the latest stock market information from the experts.

However, even most "experts" admit they have a difficult time beating the major stock indexes such as the S&P 500. It's rare that an individual would own and be able to profitably monitor all 100 stocks in the NASDAQ 100 Index, for instance, let alone all 500 stocks in the S&P 500 Index! Investing in index products is easier than buying and selling individual stocks. By using stock index futures and options on futures you can have exposure to these markets efficiently and cheaply.

Financial professionals such as pension and mutual fund managers use stock index futures for managing risk. You can become part of this exciting, dynamic market too - whether you're interested in hedging or taking advantage of market opportunities. If you have an idea about where the markets are headed but don't want to worry about individual stocks or commodities, index futures and options on futures may be the way to go.

Advantages Of Trading Stock Indexes

Electronic Access - from Virtually Anywhere, Any Time:While the Dow, S&P, and NASDAQ trade on the open auction platform during regular trading hours, they also trade electronically overnight. The mini-sized contracts are fully electronic and trade almost around the clock. The electronic platform provides a level playing field. Orders are executed anonymously and on a first-in, first-out basis - no preference is given to market makers.
Lower Margins, Greater Leverage: Exchange margins for stock index contracts are very low as a percentage of contract value. More leverage provides greater exposure to price changes and allows you to take larger positions in these contracts. For example, if you bought the stocks outright in the Dow Jones Industrial Average, the most leverage available is 50%. If the DJIA were at 9,000, you would need about $45,000 to participate in the basket of stocks in the DJIA compared to the $5,400 needed to participate in the same stocks with a futures contract.
Deep, Constant, and Growing Liquidity: Volume and open interest in the stock indexes continue to grow - a clear indication of the growing liquidity and strength of these contracts.
Save 30% in Taxes: Short-term trading in stocks is taxed at a higher rate than short-term trading in commodities. For investors in higher tax brackets, this tax treatment can mean saving as much as 30% on taxes on short-term gains on commodities versus stocks!
Ease of Tracking: Monitoring and understanding price changes in the stock indexes is simple because they consist of well-known, frequently referenced companies in the media. The indexes are price-weighted, which means that a dollar change in any of these stocks will have an equal effect on the index. Quotes on stock index futures are available online or by calling your broker.
Significantly Lower Commissions: Pay a fraction of the commissions it would cost to buy the individual stocks in that index.
Multiple Trading Strategies Available: Stock index futures are easy to use whether you are bullish or bearish. Shorting stock index futures is just as easy - you are not subject to uptick rules, fees, or loans for short-selling as you can be with stocks. You can attempt to use the contract for outright speculative gain or to hedge all or part of your investment portfolio.

Sector Weightings Comparison

The exhibit below compares the sector weightings of the three major U.S. stock indexes. You can see at a glance that the technology and telecom sectors make up almost 70% of the Nasdaq 100, most of the rest of that index being consumer cyclicals and non-cyclicals. The S&P 500 is about evenly weighted in the industrials, consumer cyclical, and technology sectors and bears a far heavier exposure to the health care and financial sectors than the DJIA does. The DJIA, in keeping with its name, carries the heaviest exposure to the industrial and basic materials sectors.

The Dow

Charles Dow wasn’t a financier or broker, but a journalist. When Dow came to Wall Street in the late 1880s, bonds were the investment of choice. Investors liked securities that were backed by hard assets such as real machinery and factories. They felt reassured by the predictability of income that bonds offered, as well as the specific dates of maturity when their principal would be returned. The stock market by contrast dealt in "shares of ownership'' which had no specific claim on anything a company owned. Investors on Wall Street found it difficult to analyze the daily jumble of “up a quarter” and “down an eighth,” or whether stocks generally were rising, falling, or staying even. Charles Dow devised a stock average to sort out the confusion. First published on May 26, 1896, the Dow Jones Industrial Average consisted of a dozen stocks and debuted at 40.94 points. The stock averages he devised provided a barometer for outsiders to gage the market. If you ask the average investor what ''the market'' did today, you can be sure that answer will be the performance of the Dow industrials.

Only one of the original 12 stocks, General Electric, is included in the average today. And even GE dropped out for a while - deleted in 1898 and returning nine years later as a replacement for Tennessee Coal & Iron. Several companies in the 1896 average are ancestors of firms active today. For example, American Tobacco was broken up in 1911 but was the progenitor of such companies as Fortune Brands and R.J. Reynolds Tobacco. Over the years the number of components included in the average has increased from 12 to 20 to 30 as the U.S. economy has expanded.

For the first 25 years or so of its existence, the industrial average was mostly absent from headlines in the financial press. Investors focused mainly on the action of individual stock issues rather than the market as a whole. When they did look at market averages, they were more likely to look at railroad stocks, the blue chips of the day, than at industrial stocks, which were considered speculative. It was in the roaring ’20s that the public first became very familiar with the industrial average. That was when hordes of average citizens began buying stocks by the bundle. Their enthusiasm carried the industrial average from around 100 in 1924 to nearly 400 by mid-1929.

The big crash of ’29 thrust the Dow Industrials to true prominence. Investors were desperate for a way to gauge the overall damage, and the Dow Industrials made front-page headlines. On Oct. 28, 1929, The Wall Street Journal's main headline announced that the ''Industrials'' were ''off 38.33.'' The next day, they fell another 30.57 points. In six days, the industrial average lost more than 96 points, nearly 30% of its value.

The Wall Street Journal editors determine which stocks are to be in the average. Since stability of composition enhances the trust that many people have in the industrial average, changes aren’t made often. Between 1939 and 1956, there were no changes the industrial average. Since 1956, however, there have been substitutions of agricultural products and basic materials such as iron, lead, coal, and rubber to technology companies, manufacturers, retailers, and financial services providers. For example, American Express was added in 1982, McDonald's in 1985, J.P. Morgan in 1991, and Hewlett-Packard in 1997. Most recently, in 1999, Home Depot Inc., Intel Corp., Microsoft Corp., and SBC Communications were substituted for Chevron Corp, Goodyear Tire & Rubber Co., Sears, Roebuck & Co., and Union Carbide Corp. In 1999, Nasdaq stocks (Intel and Microsoft) were added to the Industrial Average for the first time. Previously, all stocks in the Dow Industrial Average had been listed on the New York Stock Exchange, although that wasn't a requirement for admission to this exclusive "club." These changes were made to better reflect the stock market and the general economy. The Dow's durability is in the selection of companies that make up the Industrial Average. Though there is occasional criticism of this assemblage, collectively, the 30 Dow industrial stocks represent every important sector in the stock market. These companies have market capitalizations ranging from Eastman Kodak’s $8.3 billion to General Electric’s $288 billion. Clearly, these are the bluest of the blue chips.

Dow Jones Sector Weights

The DJIA delivers exposure to a diversified cross section of the U.S economy. As Exhibit 2 shows, the industrial sector is the most heavily represented. However, the DJIA also provides significant exposure to stocks in the consumer non-cyclical, consumer cyclical, technology, basic materials, health care, financial, telecom, and energy sectors.

S&P 500

Standard & Poor’s (S&P) introduced the well-known S&P 500 Index in 1957. The S&P 500 Stock Index is based on the stock prices of 500 large-capitalization companies and is designed to be an accurate proxy for a diversified equity portfolio. The Index has long been the benchmark by which professionals measure portfolio performance. Since its inception when the initial 500 stocks comprised 90% of the market value of all companies in the New York Stock Exchange, the S&P has been mandated to include the leading companies in the leading industries in the U. S. economy. Accordingly, the S&P 500 has evolved into a large cap index. As of December 31, 2002, the median market cap of the companies in the S&P was $6.764 billion and the S&P 500 had a total market capitalization of $8.107 trillion, accounting for approximately 80% of the market value of the more than 7,385 companies in the Standard and Poor’s internal database.

NASDAQ 100

The NASDAQ 100 Index comprises 100 of the largest domestic, non-financial common stocks listed on the NASDAQ Stock Market. The NASDAQ 100 Index was created on February 1,1985 with a base value of 250. After reaching nearly 900 on January 3, 1994, the index was halved. At market close on December 18, 1998, the index methodology was changed to a “modified capitalization weighting” to ensure a more diversified index. The NASDAQ 100 index is rebalanced quarterly.

Contract	NASDAQ Futures	E-Mini NASDAQ
NASDAQ 100 Futures Overview
Symbol	ND	NQ
Contract Value	$100 x ND futures price - e.g. $120,000 if ND futures price = 1200	$20 x ND futures price - e.g. $24,000 if ND futures price = 1200
Contract Months	Mar, Jun, Sep, Dec	Mar, Jun, Sep, Dec
Minimum Fluctuation	0.50 index points = $50	50 index poinst = $10
Hours (CTS)	Open Auction: 8:30am - 3:15pm Mon - Fri GLOBEX: 3:45pm - 8:15am Sun - Fri	Electronic: 5:30pm - 3:15pm Sun - Fri

Source: CME, Contract specifications subject to change without notice.

Trade The Stock Indexes

Introduction to Stock Index Futures