For the equities that make up each market, stock markets around the world use a number of “Indices.” Each Index represents a certain industry sector or the entire market. In many situations, these indices are trading assets in and of themselves, a feature known as “Index Trading.” An Index is a composite representation of the companies that make up the Index (also known as “components” of the Index).
The S&P 500 Index, for example, is a broad market index in the United States. The 500 largest corporations in the United States by market capitalization make up this Index (also referred to as “Large Cap”). The S&P 500 Index is also a trading instrument in the Futures and Options markets, where it trades under the symbols SPX in Options and /ES in Futures. The SPX and the /ES can be traded by institutional investors as well as individual investors and traders. The SPX is only available for trading during regular market hours, whereas the /ES is available in the Futures markets practically 24 hours a day.
The popularity of index trading can be attributed to various factors. Because the SPX and /ES represent a microcosm of the entire S&P 500 index of firms, when an investor buys one SPX or /ES Option or Future contract, they instantly gain exposure to the full basket of stocks that make up the Index. This offers instant diversification into the greatest firms in the United States, all wrapped up in the ease of a single security. To prevent the volatility associated with holding only a few firm stocks, investors always seek portfolio diversification. Purchasing an Index contract is a simple approach to gain diversification.
The second reason for the popularity of Index trading is the design of the Index itself. When it comes to price fluctuation, every firm in the Index has a definite link with the Index. For example, we frequently see that when the Index rises or falls, the bulk of the component stocks follow suit. For similar swings in the Index, certain stocks may increase more than the Index and certain stocks may decline more than the Index. The “Beta” of a stock is the relationship between it and its parent Index. The Beta for any stock is computed by looking at past price correlations between a Stock and an Index, and it is available on all trading platforms. By buying or selling a specified number of contracts in the SPX or /ES instruments, an investor can hedge a stock portfolio against losses. Trading platforms have advanced to the point where they can “Beta Weigh” your portfolio against the SPX and /ES in real time. When a broad market meltdown is imminent or already underway, this is a significant benefit.
The third benefit of index trading is that it helps investors to take a “macro view” of the markets when trading and investing. They no longer have to be concerned about the performance of individual companies in the S&P 500 Index. Even if a very large firm experiences hardship in their business, the influence on the wider market Index is mitigated by the fact that other companies may be performing well. This is exactly what diversification is designed to accomplish. Investors can modify their strategies based on broad market fundamentals rather than the subtleties of particular companies, which can be difficult to follow.
The disadvantages of index trading are that broad market returns are typically in the mid to upper single digits (around 6 to 8% on average), whereas investors can achieve much higher returns from individual stocks if they are willing to accept the volatility that comes with owning individual stocks.
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