If you are an Options trader, you know you can buy or sell an option based on an index or a stock. But have you ever wondered who creates the underlying index or where it comes from? In this article, Kris Monaco, Director of New Product Development for the International Securities Exchange (ISE), talks about a few of the new indexes ISE has recently introduced.

A Penny for Your Thoughts
By Kris E. Monaco, Director of New Product Development, ISE
June 20, 2007

Most investors have heard of well-known indexes such as the Dow Jones Industrial Average or the S&P 500. These indexes provide investors with an established benchmark to track the performance of the U.S. equity market. While the DJIA and S&P 500 are broad-based indexes, specialized indexes also exist for investors to focus on a particular segment of the market. The International Securities Exchange (ISE) has created a portfolio of these indexes for investors to use as a benchmark to evaluate particular sectors or to gain exposure to these niche segments through investing in exchange traded funds (ETFs) or trading options.

Over the past few months, ISE has expanded its family of indexes. The list includes notable emerging sectors like Natural Gas, Water and Homeland Security, as well as some unique areas of focus, such as "ChIndia", Wal-Mart Suppliers and SINdex.

In all cases, ISE's sector indexes focus on portfolio size and composition, basing the index on the core stocks that most effectively represent the industry sector. Using a short list of stocks makes portfolio replication simpler, which allows equity funds to easily use the indexes as benchmarks and ensures that the index functions as a "pure play" indicator of the sector's performance.

So with all of that said, what has the ISE been up to?

The ISE-Revere Natural Gas index is currently the basis for a new ETF from First Trust Advisors. The index was jointly developed with Revere Data, an independent research data and investment analytics firm. Revere provides extensive historical financial data that helps target companies that derive a substantial portion of revenues from natural gas exploration and production. Its data also allows us to screen candidate stocks by certain performance variables such as P/E ratio and Return on Equity (ROE), as well as statistical measures. This rigorous screening process is done to optimize the performance of the index and to ensure that it has significant correlation to the price of natural gas.

ISE has also worked with First Trust Advisors to create funds based on the ISE Water index and our ChIndia index. The Water index, similar to Natural Gas, is a "growth" story because the water industry has frequently been compared to other natural resources that are being consumed at greater rates. The portfolio focuses on companies engaged in wide-ranging activities in the industry, from the purchasing, storage, testing, distribution and sale of water, to collection, treatment and disposal of wastewater.

ISE's ChIndia index focuses on the largest and most liquid stocks of companies domiciled in either China or India. As of 2005, China and India's populations were 1.3 billion and 1.1 billion respectively, collectively accounting for over 37% of the world's population. The two countries alone have a labor force that is four times the size of the entire U.S. population, providing plenty of capacity to fuel their economic development. Many investors still consider China and India to be emerging markets, but the economic rise of both countries will certainly reshape global business. "ChIndia" has quickly become a symbol of a compelling investment opportunity.

ISE has also partnered with Revere to create the ISE-Revere Wal-Mart Supplier index, an index that focuses on the performance of companies that derive a significant portion of their revenue from supplying Wal-Mart. Dozens of "household name" companies receive 10%, 20%, even 40% or more of their total revenues from Wal-Mart and its subsidiaries. Familiar companies with strong ties to Wal-Mart include The Clorox Company, Del-Monte Foods, Energizer, Mattel and Kellogg's. How have these companies faired after establishing such a strong connection to the world's largest retailer? How will they be impacted as Wal-Mart alters its expansion strategy? The Wal-Mart Suppliers Index provides greater insight when considering those issues.

The ISE-CCM Homeland Security index was jointly developed with Cronus Capital Markets (CCM), which is an independent and privately owned capital market research and consulting firm. CCM provides research and support for the index, particularly, by evaluating publicly traded companies that are most impacted by changes in homeland security spending, geopolitical risk and certain current events. Keeping in line with that goal, the index excludes defense contractors and large conglomerates, and instead focuses on companies that represent the missions of the Department of Homeland Security in a balanced fashion.

Until now, investors have approached hedging against geopolitical risk and related factors in a fragmented fashion by buying and selling certain derivatives linked to commodities, currencies or broad-market indexes. While some of those strategies may be effective, the Homeland Security index provides investors with the ability to specifically track the homeland security sector - a first for the financial markets.

The ISE Homebuilders index includes "pure-play" stocks in the homebuilding industry. Housing prices and new home sales data continue to dominate headline news, and the market demands new ways to hedge investments and speculate on real estate without taking physical delivery of a New York condo. The ISE SINdex goes even further. It crystallizes the concept of tracking a portfolio of stocks tied to traditionally perceived vices, such as smoking, drinking and gambling. Perhaps this is the "yin" to the socially responsible index "yang" (or vice versa).

So will we ever see the ISE Uranium Index? Maybe. ISE is continuing to create new indexes all the time - so stayed tuned for more creative products in the future. If you would like to learn more about ISE or ISE's Index Options, please visit www.ise.com.

Kris Monaco is Director of New Product Development at the International Securities Exchange (ISE). ISE operates a family of innovative securities markets which include an options exchange, a stock exchange and an alternative markets platform. ISE's options exchange is currently the world's largest equity options exchange.

Options involve risk and are not suitable for all investors. Because they are cash settled, investors should be aware of the special risks associated with index options and should consult a tax advisor. All option accounts require prior approval by Scottrade. Detailed information on our policies and the risks associated with options can be found in Scottrade's Options Application and Agreement, Brokerage Account Agreement, and Characteristics and Risks of Standardized Options (available from your local branch office or at www.optionsclearing.com/publications/risks/riskchap1.jsp. None of the information provided should be considered a recommendation or solicitation to invest in, or liquidate, a particular security or type of security. Investors should fully research any security before making an investment decision.