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 overall market itself. In many cases, these indices are tradable instruments themselves, and this feature is called “Indices Trading.” An Index represents an aggregate picture of the companies (also known as Index “components”) 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 US companies by market capitalization (also called “large cap”). The S&P 500 Index is also tradable on the futures and options markets, and trades under the symbol SPX on the options market and the symbol /ES on the futures markets. Institutional investors, as well as individual investors and traders, have the ability to trade SPX and /ES. The SPX can only be traded during normal market trading hours, but the /ES can be traded almost 24 hours a day on the futures markets.
There are several reasons why indices trading is very popular. Since the SPX or /ES represents a microcosm of the entire S&P 500 index of companies, an investor gains instant exposure to the entire basket of stocks that the index represents when they purchase 1 option or future contract on the SPX and /ES contracts respectively. This means instant diversification into the largest companies in the US built into the convenience of one stock. Investors constantly seek portfolio diversification to avoid the volatility associated with holding just a few shares of the company. 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 has some relationship to the Index in terms of price movement. For example, we may 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 stock portfolio against losses by buying or selling a certain number of contracts in the SPX or /ES instruments. Trading platforms have become sophisticated enough to perform instant “beta weighting” of your portfolio in SPX and /ES. This is a huge advantage when a broad market crash is imminent or already underway.
The third advantage of index trading is that it allows investors to get a “macro view” of the markets in their trading and investing 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 general market factors rather than the nuances of individual companies, which can become very cumbersome to follow.
The downsides of index trading are that broad market returns typically average in the mid to high digits (around 6-8% on average), while investors have the ability to achieve much higher returns on stocks. individuals if they are willing to face the volatility that accompanies owning individual shares.