Spreading Opportunities

First, a bit of a history lesson for those who didn't experience this first hand:

Back in 2002, when the bear had its teeth firmly in control of the market, the signs of a bottom were given by the strength in the tech sector as compared to the blue chip S&P 500 Index. We measure this strength by dividing the price of the NASDAQ-100 Index (NDX) by the S&P 500 Index (SPX) and multiplying it by 100. You'll see the same thing on the Elliott Wave International website. We won't duplicate their chart here, but if you've signed up for Free Week, you can view it by going to Club EWI and logging-in with your Elliott Wave International userid and password, then clicking on the Subscriber tab, then the link entitled, "Short Term Update" (dated Friday, July 14). That will take you to a page of analysis of stocks, bonds, gold and the dollar done by Steven Hochberg. If you read his analysis, you will see that he thinks that the NASDAQ-100 is getting close to its low, while the S&P 500 Index may have considerably more to go on the downside. This would be a perfect setup for a great spread trade, but he doesn't mention that possibility. But, we are definitely going to mention it because it has such a great profit potential! And, you don't even have to care whether the whole market is going down or going up because, if you've got your "legs" correct, you couldn't care less.

If you invest and trade the stock index futures, you already have the means to trade spreads. Spreads are an incredible investment vehicle which the crowd doesn't use. Back in 2002-2003, we traded the Value Line - Dow Industrials spread and it was a consistent moneymaker. Nowadays, the volume in the Value Line has just vanished, so it's not a viable vehicle for spread trading. But, since the NASDAQ-100 and S&P 500 Indices both trade side-by-side on the Chicago Mercantile Exchange, that combination makes a dynamite opportunity for both traders and investors!

Now, before you fall off your perch laughing, listen up first. Futures spreads have some huge advantages over regular (called "outright") futures positions. First of all, the exchanges realize that spreads are inherently much less risky than outrights. They show this realization by giving you absolute huge discounts on margin requirements.

The NASDAQ-100 (e-mini) outright futures contract NQ initial margin requirement is $3750 per contract. The contract due to expire in September is currently priced at 1475. It is worth $20 per point, so one contract is worth 1475×$20 = $29,500. If we divide the contract value by its margin requirement, we get a Margin Efficiency Ratio which relates to the leverage involved in such a position. That figure is 29500/3750 = 7.86. That means that for each $1 of margin you provide as a "good faith" deposit to the exchange, the value of the contract can move $7.86 either for or against you. Remember, this is an outright position, not a spread. We'll talk about spreads after we examine each contract as an outright first.

The S&P 500 (e-mini) outright futures contract ES initial margin (same URL as above) is $3938 and that contract, valued at $50 per point, is currently worth 1242.25×$50 = $62,112.50. Its Margin Efficiency Ratio is 15.77. That ratio reflects the fact that the S&P 500 is less volatile than the NASDAQ-100.

A spread consists of a balanced position both long and short similar investments. Originally, spreads were confined to agricultural commodities, but like everything else, spreads can be created by buying and selling stock index futures, bonds of varying maturities, and almost anything else that's related. That's the key to risk reduction using spreads: relatedness. The more the long and short legs of the spread are related to each other, the less risk there is in the trade. Of course, with less risk, there's likely to be less reward.

However, the interesting thing is that there is a happy medium where short term risk is reduced, but longer term reward is enhanced via spreads. That's exactly what a position trader or investor is looking for -- a combination of characteristics which reduces overnight risk (after all, they want to sleep at night) yet doesn't limit longer term gains. We'll discuss how this is possible later, but now we want to compare the margin requirement of spreads, which is partially where those potential longer term rewards start.

The exchange recognizes the risk reduction potential of spreads by allowing a spread margin credit percentage for recognized spreads. A recognized spread, which can be found on Chicago Mercantile Exchange Spread Margin Requirements for Equity Indices, will allow your broker to require less margin. In practice, what this means is that you can put on a larger position with larger potential rewards (and larger potential losses).

In the table on the CME page, you will find this entry: E-Mini S&P 500 (ES) vs. E-Mini Nasdaq 100 (NQ). The next line shows that the "Spread Credit Rate" has a ratio of 1:2 and an Initial value of 90%. What this means is that the number of contracts on each leg of the spread must stand in a 1:2 ratio. For example, a one-unit spread would have one leg (either long or short) consisting of one contract of the ES (S&P 500 e-mini) and the other leg (either short or long, opposite the first leg) consisting of two contracts of the NQ contract (NASDAQ-100 e-mini). This makes sense because one point of the S&P e-mini is worth $50 and one point on the NASDAQ-100 e-mini is worth $20, so having two contracts on the NASDAQ side boosts the dollar value of a one-point move to $40. Since the NASDAQ side is more volatile to begin with, the moves pretty well balance out on the short term, although, as we will see, these contracts can move considerably differently over the long run.

The initial spread credit percentage of 90% means that you add up the initial margin requirements of all of the contracts and subtract 90% of that total to come up with your margin requirement. Equivalently, you can just multiply the total margin required by 10% (0.1) and get the same answer. For a one unit spread, we would have $3938 for the single ES and $7500 for the two NQ contracts, for a total required margin of $11,438 before applying the spread credit. The spread credit of 90% reduces the total to just $1,143.80. The Margin Efficiency Ratio is thus (62,112.50+2×29,500)/1143 = 105.88. This extremely high number reflects the lower risk associated with spreads.

We've mentioned before how spreads lower the risk of an event occuring which causes the entire market to drop sharply, such as 9/11. In that kind of surprise attack, the entire market will drop. Since you are long the market on one side of the spread, that leg will lose enormous amounts of money in a very short period of time -- you might not even be able to sell if the exchange is closed, in fact. But, on the short side of the spread, that leg will rise an enormous amount. While there's no guarantee that the short side will keep you from losing money, you have a much better chance than someone who is long the market. It all comes down to balancing risk and reward and spreads are a great way to accomplish that goal. But, you have to remember not to make the mistake of trying to leverage your way into quick riches or you may find yourself on the wrong end of the lever!

Long Term Profitability of Spreads

Here is a representative spread chart from 2004 and 2005 which shows the SPX-NDX spread. By convention, the long side of the spread is given as the left leg, the short side is the right leg. The left leg would have the investor long one contract of ES and the right leg would have the investor short two contracts of NQ. The chart price values are shown in dollars and reflect the difference in contract values between the left leg and the right leg. The profitability of a spread trade depends upon the difference between the exit and the entry prices of the spread. Where the curve is heading lower, the spread investor would need to reverse the legs in order to profit from the position--in other words, instead of an SPX-NDX spread, one would need to have an NDX-SPX spread:

As you can see, each swing in value was on the order of $6000. With a margin requirement of just over $1000, the potential for profit is excellent on this spread. For example, let's assume an investor capitalizes his position with three times the initial margin requirement ($3431.40) and is able to capture about half of both swings to be conservative, or only $6000 total. That would represent a 174% return on capital. How many day-traders can claim that kind of return?

The other point to note about the chart is how well the spread trends. In other words, it doesn't chop around in a trading range very much. Avoid spreads which chop around because they won't make money. When a spread "hugs" a Bollinger Band, it is trending well and this one was trending very well during the time period studied.

Continuing our study we look at 2005. As you can see, for most of the time the spread trended very well as the outperformance of the NASDAQ-100 outpaced the S&P 500. The downward trend ended early this year and the spread bottomed at -5591. Here's what the spread has done this year:

After some stuttering and backsliding in April, the spread has risen by $7305.

As you can see, reducing short term risk and volatility does not necessarily mean giving up the potential for large percentage gains.

At the time this chapter was originally written in the first half of 2006, the relative strength chart of NDX compared to SPX was stretched to the downside:

This was setting up a good bounce back into the middle of the bands.

Summarizing the fundamentals, we can state that the following conditions apply to this investment:

1. Periods where the economy is within six months of entering an expansion phase, such as October 2002, favor the NQ-ES (long the NASDAQ-100 e-mini and short the S&P 500 e-mini).

2. Periods when the economy's growth rate is peaking and turning down favor the ES-NQ spread.

As far as technicals are concerned, a bottom in the NDX-SPX Relative Strength Ratio is likely to signal the beginning of a period where the NQ-ES spread rebounds and provides excellent returns to investors.

The S&P 500 - Russell 2000 Spread

This is a spread where an equal number of contracts on each side are held (unlike the S&P 500 - NASDAQ-100 spread discussed earlier). The margin requirement as of 30 September 2006 for one unit of this spread (using one e-mini contract for each side) was $1463. Since the point value of the two contracts differ, $50 for the S&P 500 and $100 for the Russell 2000, the equal number of contracts on each side balances because the Russell 2000's nominal value is about half that of the S&P 500. For instance, at the close of trading on 29 September 2006, here are the contract values of the December 2006 contracts:

S&P 500 value = 1345.50 × $50 = $67,275.

Russell 2000 value = 732.10 × $100 = $73,210.

Here is what the spread did (using the cash indices to approximate what the futures spread would have done) during the 'Nineties:

And, here is what the spread did during the 'Naughties, through the end of September 2006:

Clearly, the move off the high has been quite spectacular, with just one unit of the spread declining in value deeply into negative territory. Of course, the way to profit during the 'Naughties would have been to reverse the spread. Instead of being long the S&P 500 and short the Russell 2000, profits would be made by being long the Russell 2000 and short the S&P 500.

A reversal in trend where the blue chips outperform the small stocks would again be favorable to the long S&P 500, short Russell 2000 spread.

The lessons to be learned from these examples are several:

• Spreads eliminate the need to call market direction correctly in order to make a profit. Instead, profits are taken out of the market simply by correctly determining which index will outperform another index, a considerably easier task to many than determining whether the market itself will move up or down.

• Spreads trend extremely well for longer periods of time than the underlying market direction.

• Spreads are very margin efficient due to the spread credit given by the exchange as the daily volatility is considerably lower than an outright position. Margin efficiency can mean bigger profits from spreads than outright positions when the spread is trending well.

• Spreads are less risky than an outright position due to the fact that news will often move both sides of the spread in the same direction. Unexpected bad news would tend move the market sharply lower, but it moves both sides of the spread lower, increasing the value of the short side of the spread. This allows the spread to be held overnight, rather than day-traded, to avoid surprise developments.

The Mechanics of Order Entry

At the time this report was written, the Globex system at the Chicago Mercantile Exchange did not accept spread trades for the contracts mentioned (S&P 500 e-mini, NASDAQ-100 e-mini and Russell 2000 e-mini). The exchange does, however, recognize the lower margin requirements as detailed at their website (link given above).