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Stock markets around the world maintain a variety of “indexes” for the stocks that make up each market. Each index represents a particular segment of the industry or the broad market itself. In many cases, these indices are themselves tradable instruments, and this feature is called “Index Trading”. An index represents an aggregate picture of the companies (also referred to as the “index constituents”) that make up the index.

For example, the S&P 500 Index is a broad US market index. The constituents of this index are the 500 largest US companies by market capitalization (also referred to as “large caps”). The S&P 500 Index is also a tradable instrument in the futures and 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 option of trading SPX and /ES. The SPX is only tradable during normal market trading hours, but the /ES is tradable almost around the clock in the futures markets.

There are several reasons why index trading is so popular. Since the SPX or /ES represents a microcosm of the entire S&P 500 Index of companies, an investor instantly gains exposure to the entire basket of stocks that represent the index when buying 1 SPX option or futures contract and /ES contracts respectively. That means instant diversification into the biggest US companies, built into the convenience of a single stock. Investors are constantly looking for diversification in their portfolio to avoid the volatility associated with owning 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 itself is designed. Each index company has a certain relationship with the index with respect to price movement. For example, we can often notice that as the index rises or falls, the majority of the stocks within it also rise or fall in a very similar fashion. 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 a stock and its parent index is the “beta” of the stock. By looking at past price relationships between a stock and an index, each stock’s beta 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 number of contracts in the SPX or /ES instruments. Trading platforms have become sophisticated enough to instantly “beta weigh” your portfolio on the SPX and /ES. This is a major advantage when a large stock market crash 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 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 that company would have on the overall index of the market is mitigated by the fact that other companies may 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 company-specific nuances, which can become very tedious to follow.

The disadvantages of index trading are that the returns of the major markets generally average in the mid to upper figures (around 6-8% on average), while investors have the opportunity to earn much larger returns. from individual stocks if they are prepared for the volatility that comes with owning individual stocks.

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Source by Wendy Peterson