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 general market itself. In many cases, these indices are tradable instruments themselves, and this feature is called “Index Trading”. An Index represents an aggregate picture of the companies (also known as Index “constituents”) that make up the Index.
For example, the S&P 500 index is a broad market index in the United States. The constituents of this index are the 500 largest companies in the US by market capitalization (also called “large cap”). The S&P 500 Index is also a tradable instrument in the futures and options markets and 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 SPX and /ES. SPX can only be traded during regular market trading hours, but /ES can be traded almost 24 hours a day in the futures markets.
There are several reasons why index trading is very popular. Since the SPX or /ES represents a microcosm of the entire S&P 500 company index, an investor gains instant exposure to the entire basket of stocks that represent the index when they purchase 1 SPX futures or option contract and /ES contracts. respectively. This means instant diversification to the largest US companies built into the comfort of a value. Investors constantly seek portfolio diversification to avoid the volatility associated with owning just a few company shares. 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 designed. Each company in the Index bears some relationship to the Index with respect to price movement. For example, we can often notice that when the Index goes up or down, most of the stocks within it also go up or down in much the same way. Certain stocks may rise more than the Index and certain stocks may fall more than the Index for similar movements 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 an index, the beta for each stock is calculated and is available on all trading platforms. This allows an investor to hedge a portfolio of shares against losses by buying or selling a certain number of contracts in the SPX or /ES instruments. Trading platforms have become sophisticated enough to do instant “beta weighting” of your SPX and /ES portfolio. This is a great advantage when a broad market decline is imminent or already underway.
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 the performance of individual companies in the S&P 500 Index. Even if a very large company were to face adversity in its business, the impact this company would have on the Broad Market Index is tempered by the fact that other companies might 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 the nuances of individual companies, which can become very cumbersome to follow.
The downsides of index trading are that returns from the general markets are typically in the mid to high-single digits (about 6-8% on average), while investors have the ability to achieve much higher returns from stocks. if they are willing to face the volatility that comes with owning individual stocks.
