The stock market has made a lot of noise this week with the Dow Jones Industrial Average climbing above 15,000 for the first time in history. In fact, all of the major averages are up about 18% year to date. There is a general consensus that the massive liquidity operations the Federal Reserve board has implemented are the primary contributor to the market’s rally. However, there are several competing theories as to where the top may be. This week, we’re going to take a look at seasonal tops in the Russell 2000 small cap stock index compared to the S&P 500 large cap index to try and lock in some profits while minimizing downside risk.
The Russell 2000 is a stock index made up of small companies with a median market capitalization value of around half a billion dollars. This compares to the S&P 500 market capitalization average of nearly 28 billion dollars. Another way of putting this in perspective is that the Russell 2000’s largest company by market cap is Alaska Air as compared to the S&P 500’s largest company, Apple. The important thing here is to differentiate the small cap growth stocks of the Russell 2000 from the large caps that make up the S&P 500.
The reason for this is that small caps and large caps tend to behave differently. Small caps tend to lead. Therefore, they overshoot the tops and the bottoms. The smaller nature of the stocks in the Russell 2000 means that it takes less money to move the underlying stock. Small companies are also easier to grow. Of course, extra growth comes with extra risk. The composition of the Russell 2000 changes regularly due to new companies being added while others are removed. The large cap indexes like the S&P 500 are more stable due to the massive size of the companies it’s comprised of. Steady, stable, predictable growth is what is hoped for in the S&P 500.
We’ve all heard the old adage, “Sell in May and walk away.” There is a bit of truth to this as the primary stock market gauges are typically flat through the summer with a bit of upside bias and lots of downside volatility. In fact, this seasonality is even more pronounced in the Russell 2000, which tends to bottom in August. In other words, growth is minimal while full risk exposure remains. This is not an ideal risk to reward scenario. Over the last ten years, the Russell 2000 has called the late spring / early summer top correctly eight times. The two years it was wrong were 2008 and 2009 when the markets had already been beaten down. The average profit on the trade I’m about to detail was $4,250 for the other eight years.
There are two different ways to lay this trade out. The complicated way would be to find the least common multiple of the underlying futures contracts and work out the rest of the equation as percentages and then translate the percentages back into dollars and cents. Fortunately, we can simply use the futures contracts as they are and buy an S&P 500 futures contract while simultaneously selling a Russell 2000 futures contract.
This application takes advantage of the Russell 2000’s larger built in multiplier. Calculating the value of the Russell 2000 futures contract is as simple as multiplying the index by its $100 multiplier. Thus, a June mini-Russell 2000 contract trading at 970.00 has a cash value of 970.00 X $100 = $97,000. Meanwhile, the mini-S&P 500 has a built in $50 multiplier. Therefore, the mini-S&P 500 futures contract has a cash value of 1625.00 X $50 = $81,250. Buying one mini-S&P 500 futures contract and selling one mini-Russell 2000 creates a net short cash value of $15,750 worth of small cap stocks.
The maximum value for this spread position was $16,671 in May of 2011. This represents the farthest the Russell 2000 futures have climbed above the S&P 500. We recently made a high of $16,200 two weeks ago. Currently, this spread is trading at $15,350. I expect the recent April high to hold. If the market trades above the recent high of $16,200, I will exit the trade at a loss. Recently, the average price for this spread is around $11,500. Therefore, I will use this support as the first place to look for profits. This sets up a trade that is slightly short the stock market through exploiting seasonal and market capitalization biases. Furthermore, this trade has had a relatively high historical winning percentage and is currently providing us with a 4-1 risk to reward ratio.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.