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 market itself in general. In many cases, these indices are tradable instruments themselves, and this feature is known as “Index Trading”. An index represents an aggregated 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 components 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 negotiable instrument in the futures and options markets, and trades with the symbols SPX in the options market and with the symbol / ES in the futures markets. Institutional investors, as well as individual investors and traders, have the ability to trade the SPX and the / 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 index trading is very popular. Since the SPX or the / ES represents a microcosm of the entire S&P 500 index of companies, an investor is instantly exposed to the entire basket of stocks that the Index represents when they purchase 1 option or futures contract on the SPX and the / ES contracts. respectively. This means instant diversification for the largest US companies, built into the convenience of a single value. Investors constantly seek portfolio diversification to avoid the volatility associated with owning 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. All companies in the Index have some relationship to the Index when it comes to price movement. For example, we can often notice that when the Index goes up or down, most of its component stocks also go up or down in much the same way. Certain stocks may go higher than the Index and certain stocks may go lower 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 of each stock is calculated and is available on all trading platforms. This allows an investor to hedge a portfolio of stocks against losses by buying or selling a specified number of contracts on the SPX or / ES instruments. Trading platforms have become sophisticated enough to instantly “beta weigh” your portfolio to the SPX and / ES. This is a great advantage when a general market crash is imminent or is already underway.

The third advantage of index trading is that it allows investors to have a “big picture” of the markets in their trading and investing approaches. They no longer have to worry about the performance of individual companies on the S&P 500 index. Even if a very large company were to face adversity in their business, the impact that this company would have on the overall market index is mitigated 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 individual company nuances, which can be very cumbersome to follow.

The downside to index trading is that broad market returns generally average in the middle digit or higher (around 6 to 8% on average), while investors have the ability to achieve much higher returns from individual stocks. if they are willing to face the volatility that accompanies owning individual stocks.