priv msg on index weighting:
The dow is a price weighted index. Most of the industry specific indexes are price
weighted as well.
The SPX, NDX, NASDAQ, Russell, Amex etc are capitalization weighted indexes.
There are two major problems with price weighted indexes:
1. All stocks in the index have the same effect or power over it. For instance, if Kodak
was up 4 and GE was down 4, the overall effect on the DOW would be nill while the
SPX would get crushed.
2. Splits are tricky to handle on price weighted indexes. In a price weighted index,
each stock has it's own divisor and the index is a function of the sum of these divisions.
When a split occurs, the divisor of the splitting stock has to be adjusted so the overall
effect of the split does not change the value of the index. This has an interesting and
subtle secondary effect and those who trade options on price weighted indexes should
be aware of this. After a split, the volatility of the index drops and hence option
premium. The best example of this that I remember was when TXN last split and
premium vanished from the SOX options causing everyone to curse the evil MM's.
They should have been ready for it and could have profited.
Cap weighted index values are roughly the sum of the market caps divided by a single
divisor. This divisor is some times marginally adjusted as companies get added and
dropped from indexes. Splits cause no change whatsoever.
Well, I kind of got carried away on the split issue. The important thing was realizing the
difference. That's why the Nasdaq, NDZ and SPX can all be going in one direction
and the DOW the other. If the DOW was cap weighted, even with 30 stocks, this
would occur much less often. |
