The Standard and Poors (S&P) 500 Index is the benchmark U.S. equity index. When the talking heads on news networks discuss the movements of the market, they often talk about other indices, including the Dow Industrial Average. When the pros talk about the broader equity market, they refer specifically to the S&P 500 index. The SPX Index is a market capitalization-weighted index of the 500 largest US listed publicly traded companies. Additionally, the index uses other criteria to determine if a stock should be in the S&P 500 index. The SPX 500 index is part of the S&P Global 1200 family of indices.
S&P Index Price Construction
As mentioned, the S&P 500 Index is a market capitalization-weighted index. The market-cap of the Standard and Poors index is constructed by taking the stock price and multiplying it by the outstanding shares. The Standard and Poor’s 500 index only uses free-floating shares. These are shares that the public can trade. It does not include stocks meant exclusively for executives to control the company.
Standard and Poors can alter the market cap of each company to adjust for new share issues or company mergers. The market value of the standard & poor’s 500 stock index is derived by summing the adjusted market capitalization of each company in the sp index 500 and dividing the result by a divisor. Unfortunately, the divisor is proprietary, and this information is not released to the public. While all the information is not entirely known, what is clear is that a company with a 10% weighting will have a more significant impact on the value of the standard & poor’s 500 stock index than a company with a 2% weighting.
The Limitations of Investing in the S&P 500 Index
One of the issues that can arrive when evaluating the S&P and other market-cap-weighted indexes is when stocks in the index become overvalued. This concept means that stock prices rise beyond what many believe the fundamentals warrant. The heavy weighting of an overvalued stock in the index typically inflates the overall value or price of the index. One of the alternatives is to create an equally weighted index. In this type of index, a company’s stock price has an equal impact on the value of the index.
Investing in the S&P 500
There are several ways that you can invest in the S&P 500 index. Most of the investment products that are available track the movements of the sp index 500. These products include S&P 500 futures investing, S&P 500 Index futures options investing, S&P 500 Index ETF Investing, S&P 500 Index CFD investing.
S&P 500 Futures
One of the most used investment tools that tracks the movements of the spx index futures is the e-mini S&P 500 futures contract. A futures contract is the obligation to deliver an asset to the buyer at a specific date in the future. You can capitalize on the 24-7 liquidity of E-mini S&P 500 futures and take advantage of one of the most cost-effective ways to gain market exposure to the S&P 500 Index. Each futures contract equals $50 X standard and poor’s index (level). The S&P 500 index e-mini futures contract is a quarterly futures contract that settles in March, June, September, and December. This futures contract is financially settled, which means there is no exchange of the index upon settlement.
If you held the futures contract to the agreement’s expiration, you would receive the difference between the purchase or sales price minus the contract-settlement price. The majority of the futures contracts are exited before settlement. An electronically Emini traded futures contract is popular because it’s one-fifth the size of standard S&P futures. The S&P 500 index continues to transact, but the volume and open interest are smaller than the e-mini contract.
A futures contract uses margin to allow you to enhance your returns. Margin is a loan that the exchange will provide to you using the futures contract as collateral for the loan. The loan is explicitly used for trading futures. You cannot take the money out of your account to spend. Margin provides you with an opportunity to enhance your returns with less capital.
How Margin Works
Here is an example of how margin works. The Chicago Mercantile Exchange requires that you post $11,000 of initial margin for the s and p 500 futures index as of this writing. The price of the futures contract is approximately $4,300, and each contract is worth $50. If you divide the S&P Emini futures contract ($4,300 * $50) by the margin rate of $11,000, you will calculate the leverage you will receive when you purchase an S&P Emini futures contract.
Leverage allows you to generate more income from your capital. In the example provided above, you would be able to post 20% of the money you need to trade the S&P 500 Emini futures contract. Unfortunately, leverage cuts both ways. While the gains can be intriguing, the loss can be painful.
S&P 500 Options on Futures
S&P 500 Index Options on Futures provide the buyer of the option with the right but not the obligation to purchase (or sell) the futures contract at a specific price on or before a certain date. A call option provides the buyer with the right to buy; a put option gives the buyer the right to sell. The option buyer pays the seller a premium. When you buy S&P 500 index options, you need to post the premium to the exchange upfront. If you an option seller, you can short the option using the exchange margin mechanism.
Trading S&P 500 Index Using ETFs
Another popular way to invest in the S&P 500 index is through Exchange Traded Funds (ETF). An ETF is a stock-like trading instrument offered on an exchange. An ETF tracks the movements of an underlying asset. Several ETFs track the activities of the S&P 500, with the most prominent being SPDR S&P 500 ETF Trust (SPY). The expense ratio of S&P exchange-traded funds can vary from ETF to ETF. The lowest is approximately 0.3%, and the highest is over 1%. There are also leveraged ETFs that track the movement of the S&P 500 index. These leveraged ETFs will provide you with two or even three times leverage.
Trading the S&P 500 Index Using CFDs
Other leveraged products will facilitate generating exposure to the S&P 500 index. Contracts for differences are financial products that provide leverage. CFDs are not traded in the United States but are actively traded in many areas around the globe. A CFD is a financial instrument that tracks an underlying asset. Some CFD brokers provide their clients with leverage on the S&P 500 index up to 200-1. You do not own the underlying S&P 500 index and most CFD brokers do not pay a dividend on the CFD.
What you do receive is the change in the price, which will provide you with leveraged returns to the S&P 500 index. The margin that is required is enough to cover a shift in the price of the CFD. If you are in jeopardy of losing more than you hold in equity, your CFD broker will issue a margin call requesting additional funds. If the margin call is not met in a designated period, your broker might liquidate your S&P 500 positions.
S&P 500 Index Hedging
One of the most popular trading strategies used by U.S. portfolio managers to hedge their portfolios is to mitigate risk using the S&P 500 index. Since many consider the S&P 500 their bogey for performance, using a hedging tool is essential.
There are several ways that you can hedge a portfolio of stocks that correlate to the movements in the S&P 500 index. Correlation tells you how closely an asset moves relative to another investment or basket of assets. If you are a portfolio manager or even a retail trader managing a portfolio of stocks, you can use several techniques to offset your risk.
- You can short the S&P 500 futures contract
- You can short an S&P 500 CFD
- You can short an S&P 500 Index ETF
- You can purchase a put option on an S&P 500 futures contract
- You can buy a put option on an S&P 500 Index ETF
Each of these hedges will increase in value if the S&P 500 index declines in value. If you assume that your stock portfolio is made up of stocks that you purchased, an index will move somewhat in tandem with the value of your equities. To match up your hedge with your portfolio, you need to calculate the value of your equities. You can then take a percent value of your portfolio as a short position to hedge against an adverse change in the value of your stock portfolio.
Here is an example:
Consider a portfolio of individual stocks that reflects the sectors in the S&P 500 index. The S&P 500 index would then be an excellent hedging tool. This portfolio has a value of $430,000. To hedge 50% of your portfolio, you would need to short 1-futures contracts when the market value of the futures contract is $215,000 ($4,300 (price of the futures contract) * $50 (value of each point in the futures contract).
The benefit of this strategy is that you only need to post approximately 20% of that value to control your hedging activities using a margin account. If the value of your portfolio declines by 10%, you would lose $43,000 on your stock portfolio. This mark to market loss that you experience might be offset by investing in s&p 500 futures. If the futures contract fell by 10%, you would gain $21,500, providing you with a mark to market loss of $21,500 ($-43,500 + $21,500).
You could consider using an ETF or a CFD to provide you with the hedging tool. Again, you would determine the size of your portfolio and then choose the percent of the portfolio you want to hedge with the S&P 500 index. You could then short-sell a CFD or an ETF to hedge the portion of the portfolio you want to hedge.
You could also consider using put options to hedge your downside risk. A put option is a right but not the obligation to sell the S&P 500 index. Here is an example of how you would use a put option on the SPY (SPDR S&P 500 Trust ETF) to hedge your portfolio. The SPY is trading near $430 when the Emini futures contract is trading near $4300.
One exciting piece of information you need to know is that each put option contract on the ETF holds the right to sell 100-shares. One put option on the SPY ETF has the right to sell $43,000 worth of stock. If you have a portfolio of $430,000, 10-put options on the SPY will hedge your entire portfolio.
You also have a choice of where you want the right to sell the SPY. This price is called the strike price. If you’re going to have the right to sell at the market price ($430) in this example, you are buying an at-the-money put. If you want to buy a put that allows you to sell at a lower strike (say $410), you purchase an out-of-the-money put. Lastly, if you want to buy a put that has a higher strike price than the current market, you are purchasing an in-the-money option. The benefit of purchasing a put option is that the maximum loss is the premium you pay for the right to sell the SPY ETF.
Alternative Trading Strategies
The S&P 500 index provides investors with a broad-based Index to trade on a macro basis. You can also use the S&P 500 index for a market-neutral trading strategy. This concept is similar to the methodology that you would use in hedging. Instead of taking the view that the spx index price will rise or fall, you might take the view that the S&P 500 index is poised to outperform another index, such as the Dow Industrial average or the DAX, or the Nasdaq.
For example, you might determine that you think the S&P 500 index ETF at $430 will outperform the NASDAQ 100 (ETF QQQ) when trading at $360. In this situation, if you buy 100-shares of SPY at $430, you would need to short-sell 120 shares of the QQQ ETF at $360. Remember, this is considered a market-neutral strategy. The SPY only needs to outperform the QQQ for this strategy to be successful.
Both ETFs could rise, or both could fall, and you can still make money. The goal of the trade is outperformance, and this type of trade can be successful in rising and falling markets but eliminates the direct exposure to the direction of the broader market.
You also might consider trading a market-neutral strategy using sectors. The sub-sectors of the S&P 500 index are Industrials, financials, technology, utilities, real estate, materials, communications, consumer staples, and consumer discretionary. These sectors are traded as ETFs as well as CFDs.
You might purchase these sectors if you believe they will outperform the broader market and simultaneously sell the S&P 500 index. You can also buy the S&P 500 index and sell one or more sectors if you think the overall market will outperform an individual industry or a basket of sectors. You would buy and sell the same notional quantity as described above with the SPY ETF and the QQQ ETF.
The Bottom Line
The S&P 500 Index is considered the benchmark index in the United States. This index is broad-based, incorporating several subindexes, including financials, discretionary, energy, utilities, technology, communications, industrials, materials, and real estate. The index is the bogey to which portfolio managers measure their performance.
There are several ways to trade the S&P 500 index. You can buy and sell futures contracts. You can transact CFDs and ETFs. You can also buy and sell options on futures and options on ETFs. You can use the S&P 500 index to speculate on the outright direction of U.S. equities. This decision could be based on a macro view or based on technical analysis.
The S&P 500 index is also often used as a hedging instrument. You can protect yourself against adverse moves in the U.S. stock market by selling S&P 500 futures contracts or short-selling the S&P 500 ETFs. You can also short-sell S&P 500 CFDs. Another hedging technique involves purchasing put options that will provide you with downside risk against an adverse outcome.
There are also different trading strategies that you can use to make money using the S&P 500 Index beyond a directional view. You can trade a market-neutral system by selling (or buying the S&P 500 index, and simultaneously buying (or selling) the same notional value of another index like the Nasdaq or Dow Industrial Average. Market neutral trading strategies are geared toward outperformance. You can make money regardless of the direction of the SPX index. You can also trade the broader S&P 500 index versus a sub-index like the technology sector or the financial sector using ETFs or CFDs. The S&P 500 index is an excellent tool to use to enhance your trading arsenal.