This article on How to Trade One Index Against Another is the opinion of Optimus Futures.
As traders and investors, we are all aware that the four major U.S. stock indices–the S&P 500, Dow Jones Industrial Index, Nasdaq 100, and Russell 2000–are all highly correlated with one another. They make up the broader U.S. market. So, when a bull market gets underway, all of them tend to take off. And when a bear swipes down on U.S. equities, all four get whacked. Historically, that’s the general trend.
But despite their correlation, the four major indexes don’t necessarily march in lockstep either. They still hold different stocks, sizes and sectors. And because of that, the indices tend to jostle for position. Some race ahead while others fall back. But when the spread gets too wide, at least beyond their historical mean, they tend to bounce back, as if rubber bands tethers were snapping them back into place. The question is, how can you take advantage of these fluctuations and snapbacks? How can you trade one index against another?
Index Contra Index
There are many ways to speculate on whether an index has moved too far ahead or has fallen too far behind. Some use statistical measures (as what statistical arbitrageurs use). Bear in mind, however, that ultimately, markets don’t follow statistical theories–in fact, markets sometimes destroy them, as Long-Term Capital Management had learned, albeit disastrously, decades ago.
Markets follow the laws of supply and demand. Basic fundamentals. Or, markets are driven by sentiment, reactions to perceived fundamental conditions, whether true or false. It’s a simple concept to understand, though a difficult one to speculate with.
If you are keen on what’s happening with large caps vs small caps vs the tech/internet sector vs the broader market, then you might be able to trade these four indices against one another. Ultimately, how you decide which index may be too far ahead or too far behind is up to you. But the good thing is that you can trade such speculations with much lower risk using the micro E-mini index futures. If you read last week’s installment on Micro E-mini Futures, you will have noted that micros offer the potential benefits of testing the market and trading longer term positions with a tenth of the standard risk.
So if you were ever interested in trying this type of non-directional trading, the micro E-mini stock index futures might be your ticket to this corner of traderdom. Perhaps you’ll make mistakes along the way. But with a tenth of the “standard” risk, you might have more room to learn, adjusting your strategy as you improve over time.
Example 1: Nasdaq 100 vs Dow on May 2 to May 13, 2019
Because the micro e-mini index futures were launched on May 6, we will have to use the standard e-minis as a hypothetical proxy for their micro counterparts. The micros are highly correlated to the standards, so we can assume a close proximity in prices for the following examples.
On May 2, Nasdaq futures edged up toward its all-time-highs, closing around 7872.50. On that same day, the Dow futures closed at 26517.
Now, I always keep a comparison screen open to measure the performance of all four major indices. I noticed that the Nasdaq reading was at a comparative 25.49% while the Dow was only at 15.71%. Using this simple chart, I surmised that the spread between both indices was relatively wide.
Anticipating that the distance between the two would eventually narrow, a trader might have opened a short position on the Nasdaq and a long position on the Dow as illustrated at .
On May 13, the spread had narrowed, with the Nasdaq giving a reading of 4.30% and the Dow a reading of 0.09%, comparatively (based on my layout). A trader might have closed both positions as shown at .
The Nasdaq, sold at 7872.50 and covered (bought) at 7314.25, would have yielded 558.25.
In terms of $0.50 per tick micro increments, that would have amounted to a potential $1116.50 market gain.
The Dow, bought at 26517 and sold at 25296 would have raked in a market loss of -1221.
In micro $0.50 increments, that would have amounted to a potential -$610.50 loss.
Together, the spread would have grossed a positive $506 return based on one micro contract for each index.
Past performance is not indicative of future result.
Example 2: Russell 2000 vs Dow, February 11, 2019
Going a few months back to the early part of this year, we see something a bit strange on our comparison chart. The Russell 2000 is leading the pack with the Dow and S&P at the bottom. In most instances on our chart, the Russell hardly ever leads the pack, though this time it’s up ahead. Not by much though.
The comparative reading on the Russell measures roughly 5 percentage points over the Dow. Note that these figures tend to shift when you change the scale. Again, there are more precise ways to make these comparisons. But I happen to be comfortable with an at-a-glance approach (which might or might not work for you).
The speculation here is that leadership might be inverted. With strong earnings expectations for S&P 500 companies (to take place in a month or so), news of the Fed’s more dovish stance toward rate hikes, and growing optimism over the US-China trade talks, we expect the broader market to continue rallying. And the Dow companies comprise a huge though concentrated part in the broader U.S. stock market.
So we speculate that a short position on the Russell 2000 at the price of 1520.00 and a long position on the Dow at 25019.00 might be met with a narrowing spread if not a complete inversion. The arrows below show you the entry points of the potential trade:
On March 6, the distance between the two indices closed in, signaling a potential opportunity to close the trade.
The Russell futures, short from the price of 1520 on Feb 11, was covered on March 6 at the price of 1537.00 for a loss of 17 (or 68 ticks). The micro dollar equivalent would be a loss of around -$34.00.
The Dow futures, purchased at 25019 on Feb 11, was sold on March 6 at the price of 25668, a 649-point move, and a potential gain of $324.50.
Combined the indices might have returned a gross figure of $290.50.
Past performance is not indicative of future results.
Detecting Rotations in Index Leadership
Over the long haul, fundamentals drive market leadership. But the examples above are of short-term movements. Most of these movements are likely driven by market sentiment in response to the news, earnings reports, and general economic or geopolitical conditions affecting stocks.
What may cause an index to move ahead or lag behind another in just a matter of days or weeks? If not long-term fundamental data, then its likely sentiment driven (again, statistical means can be applied but be cautious of mistaking a “tracing” of reality as reality itself–especially when such reality is subject to the flux of economic fundamentals and the whims of investor sentiment).
In short, how you go about analyzing the relation of one index to another in order to go short one and long the other, this type of project is a matter of individual method, skill, and practice. The main point of this article is not only to touch upon this way of trading but to show how using micro E-mini futures can also give you a means of testing such methods with reduced risk.
Also, the micro E-mini stock index futures have lower margins that may allow you to hold positions for a much longer period–something that many smaller traders can’t do with the standard e-minis.
Holding positions for a longer period does more than just extend time on your position, it can actually open up a whole new world of trading–swing trading, position trading, or spread trading. This longer durational option, in turn, can also affect your profit potential, as you may be able to shoot for larger market swings, whereas many smaller traders who trade the standard e-minis can only accomplish similar equity gains (or losses) from smaller, often intraday movements.
In case you’re unfamiliar with the micro E-mini index futures, the symbols and specs are as follows:
- Micro Emini S&P 500: MES – $1.25 per tick (minimum fluctuation)
- Micro Emini Dow Jones: MYM – $0.50 per tick (minimum fluctuation)
- Micro Emini Nasdaq 100: MNQ – $0.50 per tick (minimum fluctuation)
- Micro Emini Russell 2000: M2K – $0.50 per tick (minimum fluctuation)
Trading correlated indices against one another is not for every trader. Not every trader will want to speculate using a method that seems, at least to most people, a bit non-linear. But non-directional trading might resonate with a few. If you decide to embark on such a project, remember to set a risk or loss limit as you develop your own personalized method or strategy.
And if it works for you, then you can add yet another unique tool to your trading arsenal, one that might provide you with trading opportunities beyond the more common domains of trending or non-trending markets.
There is a substantial risk of loss in futures trading. Past performance is not indicative of future results.