How to trade the S&P 500

Written by: Aubrey Hayward | Expert Financial Writer

What is the S&P 500, and how is it structured?

The S&P 500 (short for Standard & Poor's 500) is a benchmark stock index tracking 500 of the largest publicly traded companies in the US by market capitalisation. Created in 1957 with an initial value of 386.36, it was the first float-adjusted, market-cap-weighted index in the US, and it now includes companies listed on both the New York Stock Exchange and NASDAQ. However, inclusion in the S&P 500 requires companies to meet strict criteria beyond market cap, including organisational structure, liquidity, share availability, and positive earnings for the most recent quarter and the last four consecutive quarters.

Why is the S&P 500 regarded as a benchmark for the US stock market?

The S&P 500 represents the performance of the largest, most influential companies across numerous industries in the US. It comprises 500 of the biggest publicly traded companies and captures roughly 80% of the total market capitalisation of all US stocks. Its market-cap-weighted structure ensures that the performance of these large-cap companies, which play a critical role in the economy, reflects broader market trends and the health of the US economy. This makes it a key tool for investors and analysts to gauge overall market performance.

Which companies are part of the S&P 500, and how frequently does it change?

To be eligible for inclusion in the S&P 500, companies must be US-based and have an unadjusted market capitalisation of at least $14.6 billion, with a float-adjusted market cap of at least 50% of that threshold (as of 2023). The S&P 500 is rebalanced quarterly to ensure it remains a reliable reflection of the US economy's growth.

The index is composed of some of the world's largest firms. Its industry breakdown is approximately as follows:

How is the S&P 500 calculated, and why does its weighting matter?

First, each company's market capitalisation is determined by multiplying its current stock price by the number of outstanding shares. Next, the index's total market capitalisation is calculated by summing the market caps of all 500 companies. Then, each company's weighting is determined by dividing its market cap by the total market cap of the S&P 500, giving larger companies a more significant influence on the index's value.

This market-cap-weighted system means that gains or losses in the stock price of larger companies have a more substantial impact on the overall index. An alternative version, the S&P 500 Equal Weight Index (EWI), assigns each company a fixed weight of 0.2%, regardless of its market cap.

The index committee periodically reviews companies' eligibility for the S&P 500, and updates are made as needed, usually with a few days’ notice. The index is rebalanced quarterly to ensure the weightings reflect the companies' market caps.

How to trade the S&P 500 (US 500)

What are the various ways to trade the S&P 500?

As the S&P 500 is essentially a culminative measure of a group of stocks’ performance, it can’t be purchased in the traditional way. However, derivative providers such as Pepperstone offer other ways to gain access to its price movements, with tradeable markets such as the US 500 which mimics the S&P 500.

• Contracts for difference (CFDs). Both are derivative products, meaning their value is derived from the performance of an underlying asset. They are also leveraged products, which means you only have to put down a small percentage of the value of your trade. This can amplify both your profits and your losses, so it’s important to manage your risk with tools such as stop-losses.
• Share CFDs on ETFs, which provide indirect exposure to the S&P 500 by tracking its performance. These share CFDs trade similarly to stocks, providing a way to participate in the index's moves.

Other ways to access the S&P 500 include:

• Direct investment in ETFs such as the SPY ETF, which mirrors the index price. It trades like a stock, making it accessible to everyday investors.
• S&P 500 options. These give traders the right, but not the obligation, to buy or sell contracts on the S&P500 at a specified price before expiration. These options are standardised and typically trade on exchanges like the CME.

What technical analysis tools are frequently used for trading the S&P 500?

Almost any is the honest answer, but it always depends on what type of trader you are: short-term, day trader, medium-term, long-term, swing, etc. You must choose the style of trading that suits you and your lifestyle and then apply the appropriate tools to that time frame and your trading plan.

As with all technical analysis, the tools can be used in any time frame; there is no ‘obvious’ tool as it’s down to personal preference, practice, and backtesting, which is all possible through your Pepperstone account.

How can I manage risk when trading the S&P 500?

There are several ways to limit your exposure when trading on the S&P 500.

Stop-loss orders

A stop-loss order is one of the most common tools for managing risk in trading. This automated order triggers the reduction or closure of a position once it reaches a specific price level. Various indicators can help determine potential support or resistance levels. If the price moves beyond these levels, it often indicates a significant shift in market conditions, and closing the position can help limit further losses.

Position sizing

Taking smaller positions can help remove emotional reactions from trading and encourage discipline in your strategy. Position sizes should be tailored to the risk-to-reward profile of the trade and adjusted for changes in market volatility. Defining what ‘small’ means for your trading strategy is also essential. For example, some experienced traders limit the risk per trade to 1% of their total capital to maintain discipline.

Risk-reward ratio

Assessing the probability of success and the likelihood of loss can also help you assess your trade sizes and therefore your risk-to-reward ration. You may assign a more significant portion of capital to trades with a higher chance of success, while riskier trades should see smaller allocations. After determining the maximum acceptable loss, it’s crucial to consider the potential profit. A well-calculated risk-reward ratio, such as 1:3, means that even if only 33% of your trades are successful, you could still achieve overall profitability despite potential losses.

What factors drive the movement of the S&P 500, and should I also apply fundamental analysis?

Since the S&P 500 represents the largest and most influential US companies across various industries, it is a reliable indicator of the US economy’s performance and growth. For this reason, fundamental analysis is crucial when evaluating the index. This type of analysis involves examining key economic factors, such as macroeconomic indicators like GDP growth, inflation, and employment data, which provide insight into the economy's overall health. Additionally, constituent companies' corporate earnings reports and financial statements are scrutinised to assess their performance and potential for growth. Interest rates set by the Federal Reserve also play a pivotal role, affecting borrowing costs and consumer spending and impacting the market.

Key economic indicators include:

• GDP growth: A growing GDP signifies a strong economy and can positively affect the stock market, including the S&P 500.
• Interest rates: Lower interest rates encourage borrowing and spending, stimulating economic growth, while higher rates slow economic activity.
• Inflation: Moderate inflation suggests healthy economic growth, but high inflation can diminish purchasing power, negatively affecting consumer behaviour and corporate profits.
• Corporate earnings are vital to understanding the S&P 500’s movements. Robust earnings reports can drive the index higher, while disappointing results often lead to declines. For example, after Nvidia's earnings report on February 22, 2024, its share price surged from $674.72 to $785.38, propelling the S&P 500 to a record high. The index gained 105.23 points, closing at 5,087.03.
• Global market sentiment also significantly influences the S&P 500. Factors such as risk appetite, currency fluctuations, and geopolitical events all play a role.
• Risk appetite: Optimism about the global economy drives stock investment, boosting the S&P 500. In contrast, uncertainty leads investors to shift towards safer assets, causing the index to fall.
• Currency fluctuations: Changes in exchange rates affect multinational companies' profitability and impact their stock prices. A strong US dollar can hurt exports and reduce overseas revenue, while a weaker dollar can boost profits.
• Geopolitical events: Trade wars, political instability, and conflicts can cause volatility in global markets. Positive developments improve investor confidence, lifting the S&P 500, while adverse events increase uncertainty, triggering market sell-offs.

Additionally, specific industry trends within key sectors like technology and financials significantly affect the S&P 500. For instance, strong growth in the technology sector can elevate the entire index due to tech companies' large market caps. Similarly, trends in sectors such as healthcare, energy, and consumer goods shape the index’s overall performance, making it essential for investors to track industry-specific developments when making investment decisions.

How does the S&P 500 compare to other major indices, such as the Dow Jones and Nasdaq?

Three key differences exist between the Nasdaq Composite, the S&P 500, and the Dow Jones Industrial Average. First, the range of stocks and sectors varies: the Nasdaq Composite and S&P 500 cover a broader array of companies and sectors than the Dow. Second, the method of weighting companies differs: the Nasdaq Composite and S&P 500 use market capitalisation to weigh individual companies, whereas the Dow weights its constituents based on stock price. Lastly, the criteria for company selection vary: the Dow is more value-oriented and uses quantitative and qualitative factors to decide which companies to include. At the same time, the Nasdaq and S&P 500 have more standardised selection processes.

What are the historical returns of the S&P 500, and how can they guide my trading decisions?

The S&P 500 has gained about an average of 10.5% annually since its introduction in 1957. The S&P 500's annual average return in 2023 was 26.3%, a significant increase from the -18.1% return in 2022.1 Trading the S&P 500 is generally a short-term strategy anyway, and rarely involves ‘buy and hold’, instead taking advantage of short-term market movements in either direction.

What is the average volatility of the S&P 500, and how can I factor that into my investment strategy?

The Volatility Index, or VIX, measures the annualised implied volatility of a hypothetical S&P 500 option with 30 days until expiration. This index is based on the prices of near-term S&P 500 options traded on the CBOE, providing insight into how much the S&P 500 is expected to fluctuate over the next 30 days. Often referred to as the "fear index" or "fear gauge," the VIX

tends to move inversely with the S&P 500 – when the VIX rises, the S&P 500 typically falls. A rising VIX signals increased demand for options and higher premiums, while a falling VIX suggests lower demand and cheaper options. It's important to remember that future volatility is unpredictable, so using the VIX alongside technical and fundamental analysis is a smart strategy.

Generally, VIX levels can indicate market sentiment.

• 0-15: Low volatility, suggesting optimism in the market.
• 15-25: Moderate volatility, reflecting a typical market environment.
• 25-30: Rising volatility, indicating market turbulence.
• 30 and above: High volatility, often signalling extreme market swings.

Although you can't directly purchase the VIX like a stock or bond, you can trade instruments that track its movements, such as VIX. There are also numerous volatility-related exchange-traded products (ETPs), including exchange-traded funds (ETFs) and exchange-traded notes (ETNs), which allow investors to gain exposure to VIX fluctuations or use them to price derivatives.

What are the top real-time news sources that can help me.

Aside from utilising Pepperstone research and data releases via the platform, real-time subscription news services can be beneficial to keep up to speed with what's relevant and breaking news that affects S&P 500 pricing.

How can I monitor the S&P 500’s performance and access live price data?

You can monitor and trade the S&P 500 directly through the Pepperstone platform, providing the tools and resources to navigate this major market index effectively. Whether you're analysing its movements or executing trades, Pepperstone ensures you have everything at your fingertips to stay informed and make sound strategic decisions.