Spreading Stock Index futures—Large Caps vs. Small Caps

Part II

In part I of this series we discussed how some traders might use spread trading to take advantage of shifts in the yield curve. Now we shall turn our attention to the equity markets. Investors keep a close watch on the key benchmarks—typically they will focus on the S&P 500 and the Dow. The S&P 500 is the main benchmark that is used to measure how a portfolio manager performs. As most people are aware it’s an index comprised of large capitalization stocks. The idea is to outperform the benchmark, making investors happy. The S&P 500 is also an important economic barometer. In growing economies, the companies within the index do well and their stock prices advance thus pulling the benchmark to higher levels. This has been amply demonstrated in 2019 as the S&P 500 has mounted record after record as the year draws to a close.

But beyond the large capitalization universe lies mid and small size stocks. For now, we will focus on large caps and small caps and omit midcaps for a later discussion. The key benchmark for small capitalization stocks is the Russell 2000 Index. And at times, this area of the market can sometimes march to the beat of a different drummer—i.e. outperform or underperform. Over the past 90 or so years, small cap stocks have outperformed large cap stocks by a few percentage points (13% annualized vs. 10% annualized). This is because small cap stocks tend to grow faster, although they are riskier. Large caps within the S&P 500 tend to be steadily growing stalwarts and are less nimble. But over the short term, large caps and small caps can leap frog each other in performance. Figure 1 below illustrates how these two index exchange periods of outperformance. Although the chart compares 20 years of small/large cap performance, we will focus on the period ending 12/31/2017.

Over the calendar year 2017, the S&P 500 outperformed the small cap benchmark Russell 2000 by 6.23 percentage points. But interestingly, by summer of 2018, small caps took the lead and by July were ahead by 5.7 percentage points. Why the abrupt swing?

In a word. China. Spring and summer of 2018 marked the beginning of the trade/tariff wars between the United States and China. Now, digging deeper why would this affect large caps more and cause them to underperform? The answer lies with the large multinational companies that make up the S&P 500.  Multinational companies like Caterpillar, United Technologies, Boeing and others have more to lose in a trade war as they derive a substantial percentage of revenue from overseas. Smaller companies that make up the Russell 2000 do not have as large a global footprint and thus they’re likely to be less vulnerable from trade wars.

Again, at the end of 2018, the relationship flipped again, and large caps took the lead despite the ongoing trade war. What happened? The fourth quarter brought a serious correction in the markets and when the market falls significantly, smaller, less well capitalized stocks fall further. Hence the Russell 2000 underperformed in the latter half of 2018. Astute traders can profit from these opportunities. Sometimes they can be short term opportunities, other times they can take days, weeks or months to develop.

With the liquid E-mini and Micro E-mini S&P 500 and Russell stock index products, a trader has a unique product suite that can allow the trader to set up a spread trade that’s geared toward the trader’s market viewpoint.

Figure 1: Small cap and large cap performance over time.

Taking Advantage of Discrepancies: Small Cap vs. Large Cap

Year Russell Performance S&P 500 Performance Russell Minus S&P 500 Russell Outperforms
12/30/2000 1.64% 0.33% 1.31% Yes
12/31/2001 1.02% -13.04% 14.06% Yes
12/31/2002 -22.39% -24.22% 1.83% Yes
12/31/2003 44.97% 27.02% 17.95% Yes
12/31/2004 17.42% 10.59% 6.83% Yes
12/30/2005 3.32% 3.00% 0.32% Yes
12/29/2006 17.00% 13.62% 3.38% Yes
12/31/2007 -2.02% 4.24% -6.26% No
12/31/2008 -38.22% -40.97% 2.75% Yes
12/31/2009 25.21% 23.45% 1.76% Yes
12/31/2010 25.31% 12.78% 12.53% Yes
12/30/2011 -5.45% 0.00% -5.45% No
12/31/2012 12.31% 11.52% 0.79% Yes
12/31/2013 39.84% 31.80% 8.04% Yes
12/31/2014 3.53% 11.39% -7.86% No
12/31/2015 -5.71% -0.73% -4.98% No
12/30/2016 18.05% 8.50% 9.55% Yes
12/29/2017 12.64% 18.87% -6.23% No
7/20/2018 10.50% 4.80% 5.70% Yes
12/31/2018 -12.17% -6.24% -5.93% No
YTD 11/27/2019 21.20% 25.87% -4.67% no

Spread Trading Illustration

A trader observes that while the S&P 500 is at new records, the Russell 2000 is still about 6% below its all time high. Furthermore, he/she believes the performance gap will narrow and the Russell 2000 will attain new all-time highs. To take a position based on this opinion, the trade would require a long position in the E-mini Russell 2000 (or the micro E-mini Russell 2000) and a simultaneous short position in the S&P 500. The correct ratio according to the CME Group clearinghouse would be 2 E-mini Russell 2000 futures for each 1 E-mini S&P 500. As you can see from figure 2 below, the trade offers an 80% margin offset. The entire trade can be executed for a margin requirement of $2,460.00.

If the Russell 2000 outperforms the S&P 500, the trade should profit. Should large caps maintain and extend their out-performance, the trade will produce losses.

Figure 2

Margin offsets for E-mini Russell 2000 Spreads — Subject to Change

Leg 1 Vs. Leg 2 Ratio Margin Credit
RTY ES 2:1 80%
RTY NQ 2:1 70%
RTY YM 2:1 70%
RTY ME 5:2 70%
Spreading the E-mini Russell 2000 vs. the E-mini S&P 500 futures
Contract Exchange Initial Margin per Leg
E-mini Russell 2000 Futures CME $3,250 x 2 = $6,500
E-mini S&P 500 Futures CME $6,300 x 1 = $6,300
Position Total gross margin   $12,800
Margin Offset   80%
Total Margin   $2,590

Final Remarks

While this illustration features spreading small cap vs. large caps, one could also spread other parts of the market such as Midcaps vs. large caps or mid-caps vs. small caps. In addition, a trader could also spread foreign stock indexes such as the Nikkei 225 vs. the S&P 500 depending on which market the trader thought would perform the best. Sector futures also exist and if a trader believes that utilities for example were going to outperform the overall market, a trade exists for that opinion as well. CME Group lists 10 sector futures contracts (the 11 sectors that make up the S&P 500) and they can be spread against each other or against broad stock indexes too.

It is best to check with your FCM regarding their guidelines regarding margins (which are subject to change and subject to CME Group exchange minimum margin requirements). And don’t forget to pay attention to the correct spread ratio. Spread not done in accordance with clearinghouse ratios are subject to higher margins.


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