Stock markets world wide maintain a selection of “Indices” to the stocks define each market. Each Index represents a specific industry segment, or broad market itself. In many cases, these indices are tradable instruments themselves, and this also feature is called “Index Trading”. An Index represents an aggregate picture in the companies (also referred to as “components” in the Index) that define the Index.
For example, the S&P 500 Index is usually a broad market Index from the United States. The components on this Index would be the 500 largest companies within the U.S. by Market Capitalization (generally known as “Large Cap”). The S&P 500 Index can also be a tradable instrument inside Futures & Options markets, and it also trades underneath the symbols SPX from the Options market, and underneath the symbol /ES inside the Futures markets. Institutional investors and also individual investors and traders manage to trade the SPX as well as the /ES. The SPX is just tradable during regular market trading hours, even so the /ES is tradable almost 24 hours a day inside the Futures markets.
There are a couple of reasons why Index trading is incredibly popular. Since the SPX or /ES represents a microcosm with the entire S&P 500 index of companies, a trader instantly gets experience the entire basket of stocks that represent the Index after they buy 1 Option or Future contract in the SPX plus the /ES contracts respectively. This means instant diversification towards the largest companies inside U.S. included in the convenience of a single security. Investors constantly seek portfolio diversification to protect yourself from the volatility connected with holding a few company stocks. Buying an Index contract offers an easy way to accomplish that diversification.
The second reason for your popularity of Index trading is due for the way the Index is itself designed. Every company inside the Index carries a certain relationship while using Index in relation to price movement. For example, we can easily often realize that when the Index rises or falls, a majority with the component stocks also rise or fall very similarly. Certain stocks may rise greater than the Index and certain stocks may fall over the Index for similar moves within the Index. This relationship from the stock as well as its parent Index could be the “Beta” from the stock. By thinking about past price relationships coming from a Stock and Index, the Beta for each and every stock is calculated which is available on all trading platforms. This then allows a venture capitalist to hedge a portfolio of stocks against losses by collecting or selling a clear number of contracts from the SPX and the /ES instruments. Trading platforms are becoming sophisticated enough to instantly “Beta Weigh” your portfolio for the SPX and /ES. This is really a major advantage whenever a broad market crash is imminent or perhaps is underway already.
The third selling point of Index trading is the fact it allows investors to look at a “macro view” on the markets into their trading and investment approaches. They will no longer have to worry about how individual companies from the S&P 500 Index perform. Even if a really large company were to face adversity within their businesses, the impact this manufacturer would have for the broad market Index is dampened by the fact that other businesses could be succeeding. This is just the effect that diversification should really produce. Investors can tailor their approaches determined by broad market factors as an alternative to individual company nuances, that may become very cumbersome to adhere to.
The negatives of Index trading is returns in the broad markets usually average inside mid to upper single digits (around 6 to 8% typically), whereas investors manage to achieve much wider returns from individual stocks when willing to face the volatility that goes as well as owning individual stocks.