What Drives U.S. Stock Indices?
Know how stock indices are calculated. Some are cap-weighted, some are price weighted.
You’ve likely heard of the Dow, NASDAQ, and S&P 500. After all, countless news outlets blast their closing values nightly. And most everyone pays attention because these U.S. indices drive global markets. If you own a portfolio, it’s quite likely that you have one or more stocks that are part of an index.
Weight Your Storms
Every index comprises a set number of weighted stocks. But not all indices are weighted the same, which is something traders often overlook.
Take these three leading indices as an example: the NASDAQ 100, the Dow Jones Industrial Average (herein referred to as the Dow), and the S&P 500. The NASDAQ 100—considered a tech index by many—consists of 100 non-financial companies. This index is “capitalization-weighted” (cap-weighted), meaning the component securities are weighted based on market cap (price times the number of shares outstanding). The S&P 500 is also cap-weighted. The influence of this weighting means a handful of larger companies make up most of an index’s total market cap. Not surprisingly, larger-cap stocks can have a significant impact on the index’s movement. Peruse both indices in terms of caps. See which stocks rank in the top 10. Should these stocks move big in a single day, you’ll likely see a noticeable impact in the index’s movement. And don’t overlook that some stocks exist in more than one index.
The Dow represents 30 large-cap, dividend-paying stocks. The index is weighted by price, making it an average of all its stock prices. (That’s the total of all stock prices, divided by the number of stocks.) Price weighting means that smaller companies can make up a larger percentage of the index, but have a disproportionate influence. For example, Gavorin Com (GVRC) may have greater sway than, say, Phystil Com (PHYL), only because GVRC’s price is higher. At the closing bell, it doesn’t matter that GVRC, by market cap, is a smaller company.
Look Beyond the Clouds
Should the market move and reporters react, knowing the flow of indices will help sensitize you to which stocks are actually making moves.
In general, if the S&P 500 moves big, expect its largest-cap stocks to have potentially created the bigger impact. If you hold stock positions or options on the index, this insight can help you strategize your possible position plays. It could work the other way, too. Based on earnings reports or other public data, if you expect a big price change in one of the Dow’s top 10 stocks, you may want to trade in that particular stock.
You may have heard of “Dogs of the Dow.” Users of this strategy buy the 10 highest-yielding Dow stocks at the start of the year and then rebalance at the start of the next year. So, each year they’re investing in dividend stocks. Sure, it’s a more conservative, long-term approach. But some sophisticated traders could also add some of those “Dogs” to their plate by trading their options.
Trading the Dogs
Short-term—Through the lens of a shorter-term strategy, sophisticated options traders might consider selling puts on some of the Dogs. Say ABCD stock made it to the Dogs list and is trading at $53.38. You could sell a 50 put for, say, $2.80, less transaction costs. If the stock price stays above $53.38 through the expiration date of the options contract, your put would have expired* worthless, and you would have made $280, less transaction costs. If the stock price goes below $50 prior to expiry, you will likely be assigned the shares and end up purchasing them at $50 per share at a time when the current price of the underlying stock is lower. But, if you happen to purchase the shares before the ex-dividend date, you could potentially pick up some dividend yield.
Long-term—A longer-term strategy may involve buying vertical spreads on LEAPS (Long-Term Equity Anticipation Securities—these are options with nine months or longer to expiration) on the Dogs. Because this is a longer-term strategy, it could tie up your capital for the duration of the trade, which means you may have to sacrifice other opportunities. It can be difficult to close a position before expiration, absorb any profits or losses, and free up capital to take advantage of other opportunities.
It seems counterintuitive, but often, only a handful of stocks drive some of the markets’ most dramatic moves. Being aware of these stocks will take you one step higher on your market awareness ladder.