Stock Index Spread Opportunities

The purpose of this piece is to review the process and practice of inter-market stock index spreading.  

Stock Index Futures

Futures contracts are available based upon a number of macro U.S. indexes including the S&P 500, Nasdaq-100, the Dow Jones Industrial Average (DJIA), and the S&P MidCap 400. 

The E-mini Standard & Poor’s 500 futures contract is the most actively traded of all stock index futures worldwide.  It is cash-settled to a value of $50 x Index.   If the S&P 500 equals 1,883.95, the value of a single futures contract equals $94,198 (= $50 x 1,883.95).   Similarly, if the Nasdaq-100 equals 3,582.02, the value of a single futures contract equals $71,640 (= $20 x 3,582.02). 

Index Performance

Each of the four indexes mentioned above may be considered “macro” U.S. stock indexes as they all represent major segments of the U.S. equity market.  But because they are constructed a bit differently, they perform differently and correlate less than perfectly.  

The S&P 500 is a capitalization-weighted index of the top 500 stocks in the U.S. market.  The Nasdaq-100 represents the top 100 non-financial stocks listed on the Nasdaq system and is heavily dominated by high-tech stocks.  The DJIA is a price-weighted index of 30 established “blue-chip” industrial stocks.  Finally, the S&P MidCap 400 represents the next 400 most significant stocks after the 500 or “mid-cap” stocks. 

These indexes tend to be highly correlated.  E.g., there is a 0.924 correlation between the S&P 500 and the Nasdaq-100.  But that doesn’t necessarily mean that the two indexes will generate similar performance.  E.g., during the 3 month period concluding April 30, 2014, the S&P 500 generated a total return (including price performance and dividend accrual) of +1.58% while the Nasdaq-100 was at -2.98%. 

Source: Bloomberg

Spread Ratio and Performance

In order to place an inter-market spread, it is necessary to derive the so-called “spread ratio.”  The spread ratio is an indication of the ratio or number of stock index futures that must be held in the two markets to equalize the monetary value of the positions held on both legs of the spread. 

The following formula may be used for this purpose where Value1 and Value2 represent the monetary value (in a common currency as necessary) of the two stock index futures contracts that are the subject of the spread. 

Spread Ratio = Value₁ ÷ Value₂

For purposes of establishing the value of the futures contract, we use the spot index value and not the quoted futures price as a rule.  This practice serves to eliminate carry considerations from the calculation. 

E.g., E-mini S&P 500 futures are valued at $94,198 while E-mini Nasdaq-100 futures are at $71,640.  Thus, one may balance 10 E-mini S&P 500 futures with 13 Nikkei 225 futures.¹

Spread Ratio = Value_{S&P 500} ÷ Value_NASDAQ  ⇒  $94,198 ÷ $71,640 = 1.315 or ratio of 10:13 S&P vs. NASDAQ contracts

Spread Ratios

Spread ratios provide an indication of the appropriate way to construct an inter-market spread.  Because they are dynamic, one must be aware of the current spread ratio when placing a trade.  But spread ratios are also useful as a general indication of spread performance.  

We calculated spread ratios as the ratio of E-mini S&P 500 futures relative to the other futures contract.  Thus, when these ratios increase, it represents a sign of strength in the S&P 500 relative to the other index.  When the ratios decline, it represents relative weakness in the S&P 500. 

The most dramatic movement observed is the general decline in the S&P 500/Nasdaq-100 spread.  This might generally be explained by the poor performance of the financial sector of the market since the height of the so-called subprime mortgage crisis in 2008.  Note that the Nasdaq-100 is constructed to exclude all financials.   

Spreads between different stock indexes offer a potentially profitable means by which to take advantage of market trends in light of the variations in the composition of the indexes.

1. Because spreads generally entail reduced risk relative to outright positions, the CME Clearing House offers reduced spread margin of as little as 10% of outright requirements when the spread is placed in a prescribed ratio.  Margins and ratios vary and may be referenced on the www.cmegroup.com website. 
   
   S&P 500 options are listed on, and subject to, the rules and regulation of CME. All references to options refer to options on futures.