Today, index option traders have a wide array of products to choose from. Not only are many index options trading on the exchanges, but a plethora of exchange-traded funds [ETF] options are also available to investors. At the same time, each index or ETF is unique and, therefore, will behave differently from others. Sometimes, the differences are subtle. Other times, the differences are significant and can affect the way the investment behaves from one day to the next. For that reason, it makes sense to understand each product and what factors will influence its performance. This article looks at three key factors.

The sheer number of indices and exchange-traded funds available to investors today has become mind-boggling. For example, how many ways do we really need to trade the NASDAQ 100 ($NDX)? Options are listed on the NASDAQ 100 Index ($NDX), on the mini-NASDAQ 100 ($MNX), as well as the NASDAQ QQQ (QQQQ). All three track the performance of the NASDAQ 100, which is a list of 100 of the largest non-financial stocks trading on the NASDAQ Stock Market. So, all three will perform the same from one day to the next.

Yet, while the NDX, the MNX and the QQQQ will all perform in a similar manner, there are subtle differences among these three investment vehicles. First, the NDX and the MNX are cash indices. The only difference is that the MNX is equal to 1/10 th of the NASDAQ 100 Index. Therefore, if the NDX is equal to 1,500.00, the MNX is equal to 150.

Nevertheless, as with the Dow Jones Industrial Average ($INDU), the mini-NASDAQ 100 and the NDX are averages used to track the performance of a group of stocks. Because options are listed on the NDX and the MNX, traders can also place option strategies on the indices. However, unlike an exchange-traded fund, an index or average cannot be bought and sold. It is simply a benchmark.

The QQQQ, on the other hand, is an exchange-traded fund. Shares can be bought and sold like shares of stock. Options are also listed on the QQQQ. The options of the exchange-traded fund settle for shares. On the other hand, options on an index settle for cash. Therefore, a first important factor to consider is whether the investment vehicle is an index or ETF.

For example, the Dow Jones Industrial Index ($DJX) is an index, but the Dow Jones DIAMONDS (DIA) is an exchange-traded fund. The DJX settles for cash; the DIA settles for shares. The S&P 500 Index ($SPX) is a cash index; the Spiders (SPY) is an ETF. The SPX settles for cash; the SPY settles for shares.

The next factor to consider when studying an index is how it is constructed. The way an index is created will determine which stocks exert the greatest influence on the performance of the overall index. There are three ways to create an index:

• Market-Weighted Index -- This index was created so that companies with larger market values account for a larger percentage of the overall index. The S&P 500 Index and the NASDAQ 100 Index are examples of market-weighted indices.

• Price-Weighted Index -- This index was created so that higher-priced stocks have a greater influence on the index. This is similar to computing the average or mean and is less widely used. However, the Dow Jones Industrial Average is an example of a price-weighted index.

• Equal-Dollar Weighted Index -- This type of index was created so that each stock exerts an equal influence on the performance of the overall index. Many of the sector indices, such as the AMEX Airline Index ($XAL), use the equal-dollar method.

As an example, the iShares Biotechnology Fund (IBB) is an exchange-traded fund that tracks the NASDAQ Biotechnology Index, which is a market-weighted index consisting of biotech stocks. Notice in the table shown subsequently that the top 10 stocks within the fund account for nearly half the index. Amgen (AMGN), the largest company by market value, represents 1/5 th of the value of the index. Naturally, this one stock will have an important influence on the performance of the IBB.

The third factor to consider when studying an index or ETF is the number of components and the industry groups that comprise the investment vehicle. For example, the S&P 500 Index ($SPX) holds 500 stocks from 9 different economic sectors and a large number of industry groups. However, the AMEX Airline Index ($XAL) holds only 10 stocks from the airline industry. Therefore, if airline stocks fall, the XAL also will.

If so, however, the SPX might not decline because airlines account for only a fraction of the S&P 500 Index. As a general rule, the fewer number of stocks within the index, and the less diversification among industry groups, the greater volatility in the index.

The three key factors when considering an index or ETF, then, are: