Frederic Ruffy, Optionetics.com
June 11, 2002

Each week, Sector Watch highlights the sectors of the market that are making headlines. Sometimes a sector has performed well and a number of the stocks within the group have recorded sharp gains.  Other times, the sector is facing selling pressure and a majority of stocks within the group have been falling.  Basically, Sector Watch tries to provide the reader with the latest information about what sectors are hot, and which ones are not.  However, traders interested in monitoring the performance of the various sectors of the market need not wait for the latest installment of Sector Watch to see which sectors are moving.  Indexes can be used instead.  

Indexes serve two purposes.  First, they provide a tool for gauging the price changes in a group of stocks.  For example, the Dow Jones Industrial Average ($INDU) is a familiar index.  It monitors the performance of 30 stocks.  That is, the Dow reflects the average price of thirty stocks.  The Nasdaq Composite Index ($COMPQ) is another example. The composite index tracks the performance of all the stocks trading on the Nasdaq Stock Market.  The Dow and the Nasdaq are examples of market indexes.  Meanwhile, sector indexes are used to gauge the performance of specific industry groups, such as biotechnology, semiconductor, oil stocks, etc.  

In addition to using indexes to view the collective performance of a group of stocks, traders can use indexes as trading vehicles.  Specifically, many (not all) sector indexes have options linked to their performance.  Those that do, will have options listed on one of three exchanges—the American Stock Exchange [AMEX], the Philadelphia Stock Exchange [PHLX], or the Chicago Board Options Exchange [CBOE].  

Importantly, there is a distinction between sector indexes and exchange-traded funds [ETFs].  The Nasdaq 100 QQQ (QQQ), the AMEX Oil Service HOLDRS (OIH), and the Select Sector SPDR-Financial (XLF) can also be used to monitor the performance of sectors, but they are not indexes.  The primary difference between ETFs and indexes is that the options on funds settle for shares (like stocks), but options on indexes settle for cash.  In today’s installment of Sector Watch, the focus is strictly on indexes—and not exchange-traded funds.

The original method of creating an index, which was used by Charles Dow when he created the first two indexes (the Dow Jones Railroad Average in 1884 and the Dow Jones Industrial Average in 1896), involved simply computing the simple average, or mean, of a group of stock prices.  For example, if three stocks are used to compute an index and their prices equal $55.00, $45.00, and $50.00 a share, using the simple average would give the index a value of 50 [($55.0+ $45.00+$50.00)/3].  

Today, however, indexes are computed using more complex methods that help take into account dividends and stock splits.  There are three commonly used ways of constructing an index—the market value-weighted, the equal-dollar weighted, and the price-weighed methods.  Capitalization or market-weighted indexes are computed by adding together the market values (price times shares outstanding) of the index’s components.  Then, an index value is computed using a divisor.  The cap-weighted method has been the more common method of constructing an index through the years.  Well-known indexes such as the S&P 500 Index ($SPX) and the Nasdaq 100 ($NDX) are examples of cap-weighted indices.  The Dow Jones Industrial Average, on the other hand, is computed using the price-weighted method, which gives greater weight to higher priced stocks within the average.  Finally, the third method of computing an index is the equal-dollar method.  It has grown in popularity in recent years because each stock within the index will exert an equal influence on the performance of the total index because the equal-dollar index is constructed under the assumption that the same amount of money is invested in each of the index’s components.     

Another consideration when studying a sector index is whether the options settle American or European-style.  Most sector indexes settle European-style, but not all.  What does this mean?  American-style options can be exercised any time prior to expiration.  ETF and stock options settle American-style.   European-style options, on the other hand, can only exercised at expiration.  Most sector indexes have options that settle European-style, but not all.

For the options trader, a final item to consider when studying sector indexes is the liquidity of its options.  Some sector indexes do not have any options linked to their performance at all.  Others do have option contracts, but the options see little trading activity.  Many of the sector indexes that trade on the American Stock Exchange suffer from a lack of investor interest, trading volume, and, hence, liquidity.  All else being equal, the greater the trading volume and open interest associated with a sector index, the better it is for implementing trading strategies.  

The table below is designed to provide a summation of the more interesting sector indexes.  Simply looking at the name of the index will tell what specific industry group the index represents.  For example, the AMEX Airline Index is an index consisting of airline stocks.  No surprises there.  The table also lists the ticker symbol (which must be preceded by a $ sign to find a quote on the Optionetics.com home page), exchange where the options trade, the number of components within the index, and whether the options settle European or American-style.

Sector Index	Symbol	Exchange	Components	Settlement-Style
The Dow Jones Utility Average	DUX	CBOE	20	European
PHLX Bank Sector Index	BKX	PHLX	24	European
PHLX Box-Maker Index	BMX	PHLX	10	European
AMEX Biotechnology Index	BTK	AMEX	17	European
MS Consumer Products Index	CMR	AMEX	30	European
MS Commodity-related Index	CRX	AMEX	?	European
MS Cyclical Index	CYC	AMEX	30	European
AMEX Disk Drive Index	DDX	AMEX	10	European
PHLX Defense Sector Index	DFX	PHLX	17	European
PHLX Street.com Internet Index	DOT	PHLX	25	European
AMEX Pharmaceutical Index	DRG	AMEX	15	European
PHLX Fiber Optics index	FOP	PHLX	19	European
PHLX Forest & Paper Index	FPP	PHLX	13	European
GSTI Computer Hardware Index	GHA	CBOE	22	European
GSTI Computer Software Index	GSO	CBOE	52	European
CBOE Internet Index	INX	CBOE	13	European
MS Oil Service Index	MGO	CBOE	30	European
MS Biotechnology Index	MVB	CBOE	35	European
MS Retail Store Index	MVR	CBOE	38	European
PHLX Oil Service Index	OSX	PHLX	17	American
PHLX Semiconductor Index	SOX	PHLX	10	American
DJ Transportation Average	DTX	CBOE	20	European
AMEX Airline Index	XAL	AMEX	10	European
PHLX Gold Mining Index	XAU	PHLX	9	European
AMEX Broker/Dealer Index	XBD	AMEX	12	European
AMEX Natural Gas Index	XNG	AMEX	15	European
AMEX Oil Index	XOI	AMEX	14	American
PHLX Wireless Index	YLS	PHLX	20	European

Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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