How can you invest in the S&P 500 index?

The Standard & Poor’s 500 (S&P 500) is the largest and most important stock market index. It tracks the performance of the 500 largest companies listed on US stock exchanges. The S&P 500 is the most traded index and therefore the benchmark for thousands of funds and fund managers. While it is not possible to buy the index itself, there are several investment possibilities.

Exchange-traded funds

An exchange traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset.  It can be bought and sold on a stock exchange in the same way that a regular stock can. An ETF can be designed to track anything from the price of a single commodity to a large and diverse group of securities.

One of the most known S&P 500 ETFs is the SPDR S&P 500 ETF. This investment vehicle fully replicates the S&P 500 and generates returns which are roughly in line with the S&P 500 index (before expenses). This means that buying a share of the ETF equals to buying a unit of the current holdings, representing a small portion of each stock of the S&P 500. As the units are traded on an exchange, the unit’s price may not always reflect the underlying value of the holdings. Buyers and sellers may push the price above or below the true value of the underlying holdings in times of euphoria or fear. By looking up the symbol “SPY.NV,” traders can see the true value of one SPY unit, which is updated each morning, where NV stands for net asset value. Investors can short sell an ETF, buy it on margin, and trade it, just like any other stock on an exchange.

While the SPY is the most popular S&P 500 ETF, it is far from the only one. The Vanguard S&P 500 ETF (VOO) is a popular alternative that tracks the index and has a lower expense ratio than SPY (0.03 percent vs. 0.09 percent). The expense ratio is the proportion of a fund’s assets used for administrative costs.  In other words, a fee for purchasing a professionally managed product.

Advantages of trading ETFs:

  • Trade like a stock: ETFs can be purchased on margin, sold short and allow you to manage risk by trading futures and options.
  • Reinvested dividends: The dividends of the companies in an open-ended ETF are reinvested immediately.

Disadvantages of trading ETFs:

  • Higher costs than trading stocks: when trading ETFs, investors must also pay management fees.
  • Risk: a leveraged ETF uses financial derivatives and debt to amplify the returns of an underlying index. Certain double or triple leveraged ETFs can lose more than double or triple than the tracked index.

Futures

Futures contracts are financial derivatives that bind the parties to trade an asset at a predetermined future date and price. Regardless of the current market price at the expiration date, the buyer or seller must purchase or sell at the specified price. Futures contracts specify the underlying asset’s amount and are standardized to allow trading on a futures exchange. Futures contracts can be used for both hedging and trading purposes. Traders can use this instrument to fix the price of an underlying asset or commodity and have pre-determined expiration dates.

The price of S&P 500 futures are calculated by multiplying the index’s value by $250. For example, if the S&P 500 is at 2,500, then the market value of a futures contract is 2,500 x $250 (or $625,000). However, to open a position like this, investors must only put up a fraction of the contract value. This is the margin on a futures contract. These margins are not the same as margins for stock trading. Futures margins represent “skin in the game” that must be offset or settled.

As for E-Mini contracts on the other hand, they represent one-fifth of the value of the big contracts. If the S&P 500 level is at 2,500, then the market value of a futures contract is 2,500 x $50 (or $125,000).

Although there is no legal minimum for day trading futures, some brokers have required minimums that must be met.

To determine the E-mini S&P 500, understanding the instruments and the risks it entails is essential. Futures contracts are measured in ticks, and each tick movement in the E-Mini S&P 500 is worth $12.50. Assuming a trader must use at least a four tick stop loss (the stop loss is placed four ticks away from the entry price), the minimum risk on a trade in this market is $50, or 4 x $12.50. Based on the 1% rule, the minimum account balance in this case should be at least $5,000, preferably more. If you are risking more money on each trade or taking more than one contract, your deposit must be higher.

Before beginning to trade futures, deep understanding of these following concepts is crucial:

  • Leverage: Using leverage means trading with borrowed funds. This allows high potential returns.  However, it also has the potential for significant losses. Futures markets are notorious for their use of excessive leverage.
  • After-Hours Market: Futures markets trade at a variety of times throughout the day. Furthermore, futures markets can predict how underlying markets will open. Stock index futures, for example, will most likely tell traders whether the stock market will open higher or lower.
  • Liquidity: The futures market is extremely active. High volume contract trading makes it easier to enter and exit trades. Liquidity concerns may exist for contracts with lower volume.
  • Margin: the percentage of a transaction that a trader must keep in their account. To begin, this is known as the initial margin. Federal regulations set the minimum margin value at 50% of the total transaction cost. However, brokers and exchanges can set their levels higher if they so desire. As an example, a trader can have $50,000 in their brokerage account, and they can borrow another $25,000 in leverage. Then,  trade worth $75,000 less any amount the broker requires they hold in abeyance, as margin in the account.

Advantages when trading futures:

  • Indirect investment: One of the frequently touted advantages of trading S&P 500 futures is that each contract represents an immediate, indirect investment in the performance of the 500 stocks that comprise the S&P 500 Index. Investing in specific S&P index companies may not always be desirable for many investors. Depending on their price expectations for the future, investors can take long or short positions.
  • Liquidity: Because buyers and sellers are always present in the futures markets, market orders can be placed quickly. This also means that prices do not fluctuate dramatically, even for contracts nearing maturity.
  • Extended trading hours: Many future markets trade outside of traditional market hours. Extended trading in stock index futures often occurs overnight, with some futures markets operating 24 hours a day, seven days a week.
  • Low commissions: Future trade commissions are very low and are charged when the position is closed. Typically, the total brokerage or commission is as low as 0.5 percent of the contract value. However, it is dependent on the broker’s level of service. A commission for online trading can be as low as $5 per trade, whereas full-service brokers can charge up to $50 per trade.
  • Trading long or short: traders can take short positions with future contracts, which can not be done with all stocks, due to different regulations or difficulties in borrowing stocks.

Disadvantages:

  • Leverage: while trading on margin means that potential profits are magnified, it is important to remember that it can be a double-edged sword and that losses are magnified as well.
  • Complicated products: Futures contracts can be difficult to understand for new traders, due to margin calculations and the use of leverage. 
  • Expiration dates: Future contracts have an expiration date. As the expiration date approaches, the contracted prices for the given assets may become less appealing. When future contracts expire, the delivery of the contract is obliged.

Contracts for difference (CFDs)

A Contract for Difference (CFD) is a contract in which two parties agree to trade financial instruments based on the price difference between the entry and closing prices. If the closing trade price is higher than the opening price, the seller will pay the difference, which is the buyer’s profit. The contrary also applies.

Unlike stocks, bonds, and other financial instruments, which require traders to physically own the securities, CFD traders do not own any tangible asset. Instead, they trade on margin with units that are attached to the price of a given security based on its market value.

CFD contracts do not require traders to deposit the full value of a security to open a position. Instead, they can simply deposit a portion of the total. The deposit is referred to as “margin.” As a result, CFDs are a leveraged investment product. For investors, leveraged investments magnify the effects (gains or losses) of price changes in the underlying security.

Terms related to CFD trading:

  • Spread: the difference between the buying and selling price.
  • Holding costs: charges that a trader may incur at the end of the trading day on open positions. Depending on the direction of the spread, they are either positive or negative charges.
  • Commission charges: These are fees that CFD brokers frequently charge for trading shares.
  • Market data fees: These are also broker-related expenses, such as fees for using CFD trading services.

Advantages when trading CFDs:

  • CFDs attract many brokers, are unique and frequently come with favourable margins
  • CFDs are traded in the volatile global financial markets. As a result, traders gain what is known as direct market access (DMA), which allows them to trade globally.
  • Trading long or short with equal ease. This empowers traders to profit from a falling market by taking advantage of share price declines.
  • Tradeable on Margin – CFDs are a leveraged product. Therefore you only need to deposit a percentage (typically from 5-10% for shares and 1% for indices) of the total value of the trade. This allows you to enhance returns and levels of market exposure.
  • Low transaction costs – brokerage using CFDs are usually more cost-efficient than buying shares through a full-service broker. Moreover, holding a CFD position is usually cheaper over a traditional purchase.
  • Ability to trade out-of-hours. Many providers offer extended hours. Individuals can trade some markets even after the stock market closes.
  • No fixed contract size – traders can buy and sell any number of instruments.

Disadvantages of CFDs include:

  • Leverage: while trading on margin means that potential profits are magnified, it is important to remember that it can be a double-edged sword as losses are magnified as well.
  • Higher risk: CFDs are riskier than trading shares. Although trading on margin enables you to only deposit a certain amount, it is still possible to lose the initial margin and meet a margin call. When the latter happens, traders are forced to sell their assets and contribute more cash.
  • Interest payable on the total transaction: Unlike margin lending (or any other share gearing), the CFD trader must pay interest on the total transaction market exposure, regardless of the margin contributed
  • Inflexible leverage levels: the CFD provider determines the margin level for each market. CFD traders must therefore have appropriate risk-management strategies. The broker also has the right to increase the margin required mid-trade. This means the trader may be required to contribute additional funds.

Options

Options are part of a larger class of securities known as derivatives. The price of a derivative is dependent on or derived from the price of another financial instrument.

An option is a contract that grants its holder the right, but not the obligation, to buy or sell an underlying asset at a specified strike price prior to or on a specified date. European options limit the execution to their expiration date. However, American options allows the holders to exercise the option rights at any time before and including on the day of expiration.
Call options are financial contracts. They give the option buyer the right, but not the obligation, to buy the underlying at a specified price within a specific time. An easy way to think about call options is like a down payment on a future purchase. They give the buyer the option but not the obligation to sell the underlying asset at a specific price within a specific period.  The strike price of the option is the price at which it can be exercised.

Some examples

  • Buying a call option: Buying a call option grants the owner the right to buy shares (for e.g.) of a specific stock at a predetermined price later.
  • Buying a put option: Purchasing a put option allows the owner to take a short position in the underlying asset.
  • Selling a call option: Selling a put option gives the owner a potential short position in the underlying asset.
  • Selling a put option: Selling a put gives the owner a potential long position in the underlying asset.

Terms related to option trading:

  • In-the-money (ITM) refers to an option that possesses intrinsic value. ITM thus indicates that an option has value at a strike price that is favourable in comparison to the prevailing market price of the underlying asset. For call options, this means that the option holder can buy the security below its current market price. Regarding put options, it means that the option holder can sell the security above its market price. ITM options have higher premiums.
  • At-the-money (ATM) is a situation where an option’s strike price is identical to the current market price of the underlying security.
  • Out-of-money (OTM) call options have a strike price that is higher than the market price of the underlying asset. Conversely, an OTM put option has a strike price that is lower than the market price of the underlying asset.

Mutual Funds

A mutual fund is an investment company that pools money from many investors into one large pot. The fund’s professional manager invests the money in various assets such as stocks, bonds, commodities, and even real estate. An investor purchases mutual fund shares. These shares represent an ownership stake in a portion of the fund’s assets. Mutual funds, due to their fee structures, are intended for longer-term investors and should not be traded frequently.

Stock funds invest in the stock of various companies. Stock funds frequently invest in companies based on their market capitalization, or the total dollar value of their outstanding shares.

Investors purchase or redeem mutual fund shares directly from the fund. This contrasts with stocks and ETFs, where the counterparty to the buying or selling of a share is another market participant. Mutual funds charge varying fees for purchasing and redeeming shares.

There are mutual funds that replicate or try to replicate the S&P 500 as well as possible.

Advantages of mutual funds:

  • Liquidity: When not opting for close-ended funds, it is relatively easy to buy and exit a mutual fund scheme.
  • Expert management: A mutual fund is ideal for investors who lack the time or expertise to conduct their own research and asset allocation, as a fund manager oversees everything and makes the decisions.
  • Convenience and fair pricing: Mutual funds are simple to purchase and comprehend. They typically have low minimum investment requirements and are only traded once per day at the closing net asset value (NAV). This eliminates price fluctuations throughout the day as well as the various arbitrage opportunities that day traders take advantage of.

Disadvantages of mutual funds:

  • High expense ratio: sometimes mutual fund expenses and sales charges can quickly get out of hand if not paying attention. Funds with expense ratios greater than 1.50% are considered to be on the higher end of the cost spectrum.
  • Poor trade execution: If a mutual fund order is placed before the same-day NAV cut-off time, traders will receive the same closing price NAV for their buy or sell on the mutual fund. Mutual funds are a poor execution strategy for investors seeking faster execution times, whether due to short investment horizons, day trading, or market timing.

We can conclude that there are several ways of investing and gaining exposure in the S&P 500 index. These possibilities are due to the size of the index and therefore it’s popularity. All kinds of different investors, experienced, unexperienced, risk-averse or risk-loving can find something that corresponds to them and their strategy.

Disclaimer: The content above is for informational purposes only, you should not construe any such information or other material as legal, tax, financial, or other advice.

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