Stock markets around the world maintain a variety of “indices” for stocks that make up each market. Each index represents a specific industry segment or broad market. In many cases, these indices themselves are traded instruments, and this feature is called “Index Trading”. An index is the aggregate picture of the companies (also known as the “components” of the Index) that make up the Index.
For example, the S&P 500 is a broad market index in the United States. The components of this Index are the 500 largest US companies by market capitalization (also called “Big Capitalization”). The S&P 500 is also a traded instrument in the futures and options markets, and it is traded under the SPX symbols in the options market and under the / ES symbol in the futures markets. Institutional investors as well as individual investors and traders have the opportunity to trade SPX and / ES. SPX can only be traded during normal hours of market trading, but A / ES can be traded almost 24 hours a day in futures markets.
There are several reasons why index trading is so popular. Because SPX or / ES is a microcosm of the entire S&P 500 companies ’index, an investor instantly gains access to the entire basket of stocks representing the index when they buy 1 option or a future SPX contract and / ES contracts. respectively. This means instant diversification to the largest companies in the US, built into the convenience of one security. Investors are constantly looking to diversify their portfolio to avoid the volatility associated with holding just a few stocks of a company. Buying a contract on the index provides an easy way to achieve this diversification.
The second reason for the popularity of index trading is due to how the index itself is designed. Every company in the Index has a certain relationship with the Index when it comes to price movements. For example, we may often notice that when an index rises or falls, most component stocks also rise or fall very similarly. Some stocks may rise more than the index, and some stocks may fall more than the index for similar movements in the index. This relationship between the stock and its parent index is a “beta” of the stock. Looking at the past price relationship between the stock and the index, the beta for each stock is calculated and available on all trading platforms. This then allows the investor to hedge the stock portfolio from losses by buying or selling a certain number of contracts in SPX or / ES instruments. Trading platforms have become sophisticated enough to instantly “beta weigh” your portfolio in SPX and / ES. This is a major advantage when a widespread market collapse is imminent or is already underway.
The third advantage of the index trade is that it allows investors to get a “macro view” of the markets in their trading and investment approaches. They no longer have to worry about how individual companies perform in the S&P 500. Even if a very large company faces difficulties in its business, the impact that this company will have on the Broad Market Index is exacerbated by the fact that other companies may be well . This is the effect that diversification should bring. Investors can adapt their approaches based on broad market factors rather than individual nuances of the company, which can be very cumbersome to follow.
The downside of index trading is that broad market returns tend to average single figures (6 to 8% on average), while investors have the opportunity to make much higher returns on individual stocks if they are willing to face volatility that goes along with owning individual stocks.