What is the S&P 500, and Why Does It Matter to Traders at Banks?

This article was guest-written by SilverSurfer, a former prop desk derivatives trader on Wall Street and founder of LifeStyleTrading101.com, a site that teaches you how to generate consistent weekly income from the stock market. He provides daily analysis of the S&P 500, lessons on how to use options, and weekly podcasts on iTunes.  In addition to trading, Mr. Silver has taught the GMAT at GMATPill.com, a popular GMAT prep resource with thousands of GMAT practice questions for MBA candidates.

“The S&P was down 1% in early trading…”

“Although the S&P was up 7% for the year, only about half the individual stocks were up…”

“Sell, sell, sell!”

You constantly hear the “S&P” or “S&P 500” used in stock-market discussions, whether it’s Jim Cramer screaming about something… or a trader at a bank also screaming about something.

However, few people ever define what the S&P 500 is, why it matters so much, and how professional traders use it.

In this article, we’ll take a deeper look at those points and help you set yourself apart in sales & trading interviews with superior knowledge of the S&P 500:

Definitions: How Do You Become One of the 500?

The S&P 500 is an “index,” or collection of 500 widely held stocks on the New York Stock Exchange (NYSE) and NASDAQ.

Companies based in countries outside the U.S. can be included in the index, but they must be listed on the NYSE or NASDAQ; in practice, though, the vast majority of S&P 500 companies are based in the U.S.

It does not include private companies, so giants like Saudi Aramco, Ikea, and Cargill could never be there.

Standard & Poor’s (infamous for their CDO ratings during the financial crisis…) created the index to track overall stock market performance across a broad set of industries and companies.

So it’s quite different from the Dow Jones Industrial Average (DJIA), which tracks only 30 large-cap companies, and it’s also more diverse and less tech-focused than the NASDAQ index.

Here’s a visual of each company’s relative size in the index:

S&P first created an index to track a smaller number of stocks in 1923, and eventually expanded it to 500 stocks in 1957.

Selection Criteria: Humans or Rules?

While some indices, like the Russell 1000, are completely rules-based, the S&P 500 uses a mix of humans and rules to determine and value the index:

• Humans: A committee at S&P decides on the individual stocks in the index, based on minimum requirements for market cap, monthly trading volumes, public float, sector classification, and trading volume to float-adjusted market capitalization. The committee meets once a month to discuss possible changes.

• Rules: The value of the index is calculated with an algorithm that weights companies by market cap and “float” (the shares available for public trading). S&P calculates an “adjusted market capitalization” for each company in the index, adds them all up, and then divides that figure by a “Divisor” to calculate the index value. S&P doesn’t disclose the exact calculation for the Divisor, but plenty of people estimate it independently.

If you want more, the Wikipedia article on the S&P 500 has the details on the exact selection criteria and how the index has changed over time.

Instead of regurgitating Wikipedia, we want to address a different question here: is the index representative of the stock market or the economy as a whole?

The answer is: “Sort of, but not as much as you might think.”

Since a committee selects the companies in the index, there are always controversial omissions and inclusions.

Companies can also “lobby” to be included, which further reduces the objectivity of the index.

For example, after Starwood acquired a series of hotels from ITT in 1998, it pushed for inclusion in the index.

It didn’t work at first, but S&P eventually relented and added Starwood a few years later.

Companies lobby for inclusion in the index because their share prices usually increase after being added. Many money managers buy the entire S&P 500 index or attempt to replicate its performance via individual stocks, so a newly added company will almost always see increased demand for its shares.

Another issue is that S&P adjusts the index over time to account for changes in market cap, float, fundamentals, M&A activity, and so on.

But since the company doesn’t officially disclose the “Divisor” used to calculate the index, it’s tough to tell how representative these adjustments are.

Back in 1957, the S&P 500 represented ~90% of the U.S. stock market, but the market has grown so much that it covers only ~75% as of 2016.

Finally, because the index excludes private companies and many huge foreign companies, it’s not a great proxy for global market and economic performance.

In 1950, the U.S. GDP represented 27% of the world’s total, but by 2015, it was down to 15-16%.

And private firms in the U.S. account for around 50-60% of total sales and a good chunk of total employment, so an index of only public companies doesn’t tell the whole story on GDP, earnings, or employment.

So while the S&P 500 is a useful and widely quoted index, you also have to understand its limitations and why it’s not necessarily “objective.”

Why Trade the S&P 500 Rather Than Individual Stocks?

Since the S&P 500 is like the “average” of the entire U.S. stock market, volatility is lower when you trade it, which can make trading a bit more predictable and profitable.

Also, many financial products and securities are linked to the S&P; if you want to trade any of them, you’ll have to understand the index.

For example, futures are not available on many individual stocks, but they are available on the S&P 500 index as a whole (E-mini futures).

Even if your trading strategy involves individual stocks, you may have to use an instrument like S&P futures to mitigate risk.

Other benefits include reduced stock-specific risk, improved liquidity, and the ability to use information outside of market hours (in the case of futures).

For more, see this article on Why We Trade the S&P 500.

How Traders at Banks Use the S&P 500

The real answer to this one is “dozens of ways,” since banks organize their trading desks differently and trade different securities.

But here are just three common ways that traders at bulge-bracket banks use the S&P 500:

1) Hedging Market Risk – Traders in search of “alpha,” i.e. outperformance over a benchmark index of individual stocks, want to hedge market risk so that they are exposed only to stock-specific risk.

For example, if a trader believes that IBM will outperform the S&P, he/she might long the IBM stock while simultaneously shorting the S&P 500 via securities linked to the index, such as futures.

That way, even if the market tanks, the trader still profits as long as IBM doesn’t crash as badly as the market.

In the post-Dodd-Frank / Basel III / CRD IV world, this type of proprietary trading is less common at banks, but it is still allowed for “risk-mitigating hedging activities” and a few other cases.

2) Delta-Neutral Index Options Trading Desks – These groups may hedge directional risk in the market by offsetting their delta exposure with E-mini S&P 500 futures.

If you’ve forgotten the Greeks, “Delta” measures the option’s value with respect to changes in the underlying asset’s price. So if a stock’s price increases, the value of call options on that stock will increase, and vice versa if it decreases. A delta of 0.5 means that for each $1.00 the underlying stock price increases, the call option’s value will increase by $0.50.

Plenty of professionals trade options, but they often want to avoid directional risk because it’s so risky to bet on an individual stock’s price rising or falling. So traders might structure their positions such that they profit based on volatility instead.

Since options have both a directional and volatility component (among others), it’s possible to focus on just the volatility component and hedge away the directional component via S&P futures.

For example, if you buy a stock’s call options with a delta of 0.5, you could then short S&P futures to offset that delta and leave yourself exposed only to the options’ volatility.

This strategy is known as “delta-neutral trading,” and it lets traders focus on only the components they want to bet on.

Many traders see volatility trades via options (calls, puts, credit spreads, etc.) as higher-probability ones than directional trades, especially if volatility has been high recently.

They could use a similar strategy in flow trading when the bank is accepting client orders, and the bank takes the other side of a client’s position.

For example, if a client has significant long exposure on the S&P 500 index – via options, stocks, or any other vehicle – and the bank takes the other side, then the bank will have significant short exposure.

To counter this exposure, the bank might then long an equivalent amount of S&P 500 futures to offset this directional risk.

The bank could then execute the client’s trade, earn commissions from that, and also hedge the risk of the market going up or down.

3) Speculation – This one was more common in the U.S. before Dodd-Frank and the Volcker Rule, but trading desks can still speculate in certain cases; they just have to put more risk controls in place.

Traders often have a directional view of the market, even if they don’t hold strong views on individual stocks, and S&P-related derivatives such as futures are one of the best ways to capture that market view.

How Individuals and Day Traders Use the S&P 500

Many retail investors and day traders also speculate using S&P 500 futures and ETFs, but it’s more common to use a buy-and-hold strategy to keep ETFs that track the index for the long term.

Companies like Vanguard have made these “low fee, buy-and-hold” strategies popular.

Some individuals may use S&P derivatives to hedge market risk or to offset their delta exposure, but those are rare unless the individual is sophisticated.

S&P-Related Securities That Traders at Banks Use: Got Spiders?

Beyond the S&P futures, the SPY exchange-traded fund (ETF) is the most popular way to track the S&P 500 for both retail investors and professionals.

It’s often referred to as the “Spider,” after its full name: Standard & Poor’s Depository Receipts (SPDR), which is the security tracking the index.

ETFs act like stocks, but they are investment funds that track a collection of securities – the stocks in the S&P 500 index in this case.

ETFs are great for individuals because of the liquidity and lower fees (as they are not actively managed), and banks also love trading ETFs for similar reasons: more liquidity means smaller slippage between the bid and the ask in equity trading.

So this quality is important not only for traders at banks but also for algorithmic and quant funds that need the minimum possible slippage to profit from strategies such as high-frequency trading.

And If You’re Feeling Bored, You Can Always Use Leverage

While the liquidity and low fees of S&P-linked ETFs offer many advantages, one disadvantage is that the S&P doesn’t move as much as individual stocks do.

So if you’re trading based on volatility or using the index for something other than long-term investing or hedging, you might use a security like the UPRO (UltraPro S&P 500), which is 3x long the S&P, or the SPXS (S&P 500 Bear 3x Shares), which is 3x short the S&P.

As the names imply, these are both designed to move 3x as much as the underlying index – so if you have really strong directional views, these securities can help you capture them.

Many professionals at banks also trade the VIX, which tracks the volatility of the S&P 500 rather than its overall direction.

And then there are weekly options on the SPY ETF that expire each Friday, and E-mini Futures (ES) that, as leveraged trades, can be used for speculation or hedging purposes.

Trading Interviews: Why Does Any of This Matter?

So now you know a whole lot more about the S&P 500, but what do you need to know for trading interviews?

Obviously, you must have a rough sense of what the index is currently at – if you give a number closer to 20,000 (the DJIA range) than 2,000, you’ll look quite foolish.

You should also know about recent events such as Fed policy decisions, unemployment and GDP announcements, and other headlines that might affect the entire market.

You’re also likely to get questions on both the market’s direction and volatility, so you should have strong views on both of those. There are no “correct” answers, but there are better answers and worse answers – see our article on S&T interviews for more on that one.

But beyond those basics, you should pick a specific S&P-related security or strategy and be able to explain why you’re interested in it.

The #1 mistake students make in trading interviews is to go in and say, “I want to work in S&T because I like trading stocks.”

That’s a poor response because 1) You’re not demonstrating how banks’ trading strategies differ from those of retail investors, and 2) That same answer could apply to asset management, equity research, value-oriented hedge funds, or plenty of other fields.

So pick something – whether it’s the VIX, S&P futures, S&P-linked ETFs, or other derivatives, and explain why you like it and how you might use it at the bank.

For example, you might say something like:

“I’m interested in E-mini S&P futures (ES) because they’re one of the most efficient and economical ways of achieving leverage on a highly traded, liquid product.

On a transaction basis, they’re often cheaper to execute than regular stock trades, and they also provide that leveraged exposure without the daily compound decay in triple ETFs such as UPRO/SPXS. Leverage has its downsides, but if you’re managing a portfolio of securities, the E-mini’s are an excellent way to hedge directional exposure when you want to use a delta-neutral strategy.”

The S&P 500

Follow everything above and do your homework on an S&P-linked security, and you’ll be better prepared to discuss this index than the vast majority of interview candidates.

As long as you can say more than, “Sell, sell, sell!” you’ll even know more than Jim Cramer.

He may have a TV show, but just give it a few hours years, and you might just get one as well.

Continue this discussion on your mobile device by listening to this S&P 500 audio podcast episode.