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This week's question:

DATE: December 5, 2014

Can you explain what a proxy is and how it relates to the world of options trading?

A proxy can be defined as a substitute or an almost equal replacement. In the case of trading stocks, that is exactly what a proxy is, a substitute for a stock. A proxy is important in the world of options trading because professional options traders typically hedge their options trades with trades in the underlying stock.

For example, if a professional trader were to sell some XYZ call options, then he or she would likely buy some shares of XYZ stock to offset the market risk of the short calls. Additionally, if a professional trader were to buy put options on QRS stock, then he or she would likely immediately buy shares of QRS stock to offset the market risk of the long puts and create a positive exposure to the market.

However, when trading index options, it's often cost prohibitive to trade all of the stocks in the underlying index. The S&P 500® Stock Index is comprised of 500 individual stocks, and it would be very costly for a professional trader to buy or sell all 500 stocks every time they trade S&P 500 Index options, more commonly called SPX options. Fortunately, there are several proxies offering professional traders the opportunity to hedge their SPX options trades. To learn more about the concept of proxies, view this segment of "Ask the Institute."

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