Index Trading
Stock markets around the world maintain a variety of “Indices” for the stocks that make up each market. Each Index represents a particular industry segment, or the broad market itself. In many cases, these indices are tradable instruments themselves, and this feature is referred to as “Index Trading”. An Index represents an aggregate picture of the companies (also known as “components” of the Index) that make up the Index.
For example, the S&P 500 Index is a broad market Index in the United States. The components of this Index are the 500 largest companies in the U.S. by Market Capitalization (also referred to as “Large Cap”). The S&P 500 Index is also a tradable instrument in the Futures & Options markets, and it trades under the symbols SPX in the Options market, and under the symbol /ES in the Futures markets. Institutional investors as well as individual investors and traders have the ability to trade the SPX and the /ES. The SPX is only tradable during regular market trading hours, but the /ES is tradable almost 24 hours a day in the Futures markets.
There are several reasons why Index trading is very popular. Since the SPX or the /ES represents a microcosm of the entire S&P 500 index of companies, an investor instantly gets exposure to the entire basket of stocks that represent the Index when they buy 1 Option or Future contract of the SPX and the /ES contracts respectively. This means instant diversification to the largest companies in the U.S. built into the convenience of one security. Investors constantly seek portfolio diversification to avoid the volatility associated with holding just a few company stocks. Buying an Index contract provides an easy way to achieve this diversification.
The second reason for the popularity of Index trading is due to the way the Index is itself designed. Every company in the Index has a certain relationship with the Index when it comes to price movement. For example, we can often notice that when the Index rises or falls, a majority of the component stocks also rise or fall very similarly. Certain stocks may rise more than the Index and certain stocks may fall more than the Index for similar moves in the Index. This relationship between a stock and its parent Index is the “Beta” of the stock. By looking at past price relationships between a Stock and Index, the Beta for every stock is calculated and is available on all trading platforms. This then allows an investor to hedge a portfolio of stocks against losses by buying or selling a certain number of contracts in the SPX or the /ES instruments. Trading platforms have become sophisticated enough to instantly “Beta Weigh” your portfolio to the SPX and /ES. This is a major advantage when a broad market crash is imminent or is underway already.
The third advantage of Index trading is that it allows investors to take a “macro view” of the markets in their trading and investment approaches. They no longer have to worry about how individual companies in the S&P 500 Index perform. Even if a very large company were to face adversity in their businesses, the impact this company would have on the broad market Index is dampened by the fact that other companies could be doing well. This is precisely the effect that diversification is supposed to produce. Investors can tailor their approaches based on broad market factors rather than individual company nuances, which can become very cumbersome to follow.
The negatives of Index trading is that returns from the broad markets usually average in the mid to upper single digits (around 6 to 8% on average), whereas investors have the ability to achieve much larger returns from individual stocks if they are willing to face the volatility that goes along with owning individual stocks.
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