Narrow Focus Delivers Greater Impact

28 lis 2022

Famous American Author Alfred Paul Ries once said, “Good things happen when you narrow your focus”. Global macro conditions and monetary environment could make that quote apt for US equity market investing too.


Given the backdrop of price behavior, this case study argues that a spread trade comprising of Long Dow Jones Index and short S&P 500 index provides a potential reward to risk of 1.01.


The charts above clearly point to the strong performance in Dow Jones Industrial Average Index (DJIA Index, a narrow market index comprising of 30 stocks) relative to the broader S&P 500 index (an index of 500 stocks).


SECTOR WEIGHTINGS


Based on sector weights as published by S&P Global on 31/Oct, the table below sets out the comparative analysis of the two indices.

• Information Technology - DJIA: 19.5%, SPX: 26.3%, Difference: -6.8%, DJIA Significantly Underweight Information Technology
• Health Care - DJIA: 22.2%, SPX: 15.3%, Difference: +6.9%, DJIA Significantly overweight Healthcare
• Financials - DJIA: 16.2%, SPX: 11.4%, Difference: +4.8%, DJIA Overweight Financials
• Consumer Discretionary - DJIA: 13.3%, SPX: 10.9%, Difference: +2.4%, DJIA Overweight Consumer Discretionary
• Industrials - DJIA: 13.9%, SPX: 8.3%, Difference: +5.6%, DJIA Significantly Overweight Industrials
• Communication Services - DJIA: 2.9%, SPX: 7.5%, Difference: -4.6%, DJIA Underweight Communication Services
• Consumer Staples - DJIA: 7.5%, SPX: 6.9%, Difference: +0.6%, DJIA Overweight Consumer Staples
• Energy - DJIA: 3.6%, SPX: 5.4%, Difference: -1.8%, DJIA Underweight Energy
• Utilities - DJIA: 0%, SPX: 3%, Difference: -3%, DJIA Underweight Utilities
• Real Estate - DJIA: 0%, SPX: 2.6%, Difference: -2.6%, DJIA Underweight Real Estate
• Materials - DJIA: 0.9%, SPX: 2.5%, Difference: -1.6%, DJIA Underweight Materials

The DJIA has heavier weightage to Health Care, Financials, Consumer Discretionary, Industrials and Consumer Staples with underweight on Technology, Telecommunications, Utilities and Real Estate sectors.


We live in times of unprecedented pace of monetary conditions tightening with high interest-rate expected right through 2023 until policy pivots creating fears of looming recession and continuing geo-political conflicts.


Against such a backdrop, historically Financials and defensive sectors such as Consumer Staples, Industrials, and Health Care have outperformed rate-sensitive and growth sectors such as Technology, Real Estate and Telecommunications.


TECHNICAL ANALYSIS


The CME Micro E-mini Dow Jones Industrial Average Index futures (MYMZ2022) completed a golden crossover (10d & 200d MA) on 9/Nov. A golden crossover is generally seen as a bullish signal of an uptrend. Furthermore, the MYMZ2022 closed above the R1 for the pivot indicator on 25/Nov. If this level holds, this price point could act as a support level.


RSI for MYMZ2022 exhibits an overbought market condition with RSI at 71.25 as of closing 25/Nov. The stochastic indicator also points to the market having overbought with a reading of 97.74. Notably, the stochastic indicator displayed an intersection on 8/Nov which points to a potential reversal in the uptrend.


Meanwhile, the MESZ2022 is currently trading below the long-term (200-day) moving average and has not had a golden crossover yet. MESZ2022 also failed to breach R1 of the standard pivot twice and closed below it on 25/Nov. The pivot R1 and the long-term moving average both point to strong resistance at this level. RSI was 61.86 as of 25/Nov. The stochastic indicator shows that MESZ2022 is overbought with a reading of 94.16. Notably, the stochastic indicator displayed an intersection with the 3-day SMA signaling a potential reversal in the uptrend.


According to Goldman Sach’s 2023 Equities Outlook, they expect equities to cool off from their current rally in 2023. This is supported by historical performance during similar economic conditions. Moreover, both DJIA and S&P500’s technical signals also point to them being overbought. This could mean a correction is due for both of them. However, the DJI stands on a much stronger footing, technically, as it finds support at the long-term MA that it intersected this month. As such, the Dow is expected to be more resilient than the S&P 500 during the impending correction.


COMMITMENT OF TRADERS’ REPORT
According to CME’s Commitment of Traders (COT) report, S&P 500 traders have established net long positions. Dealers had long OI of 17.4% compared to short OI of 16.1%. Asset Managers and institutional investors had a long OI of 40.3% compared to 22.1% short. By contrast, Dow futures had dealer/intermediary long OI of 35.3% compared to 16.3% short. While institutions were 22.3% long compared to 8.9% short.


Notably, leveraged positions for S&P 500 had 26.6% short OI against 6.5% long while DJI had a roughly balanced 22.3% for long and 21.4% for short.





Charting DJIA/SPX shows that the ratio rallied in October and broke through all the resistances for the pivot indicator. November saw the ratio cool off. Both RSI and Stochastic indicator cooled off during this and currently stands neutral. The stochastic indicator recently displayed a crossover which could indicate a reversal in the downtrend.


If the ascending channel highlighted below maintains, then a DJIA and SPX spread trade would be viable over the next few months. Take profit could be set as R1 and R2 of the pivot indicator. Stop loss could be set at the Pivot point. In the chart these levels have been adjusted by accounting for the 20-day historical volatility.





IF HISTORY IS ANY GUIDE



Analysing the ratio over the long-time frame we can see that the rally over the past month is not unexpected. The DJI/SPX ratio rallied during past instances of Quantitative Tightening as well. For instance, during 2018-19, with tightening monetary conditions, the ratio rallied to 9.363 compared to a low of 8.233 in 2016.


The ratio also spiked after the tightening in 2006-08 from a low of 8.447 to a high of 10.075. Also in 2000-01, from a low of 6.984 to 9.691. Considering that the Fed has hiked rates in an aggressive manner this time around, the rapid rise in this ratio is also not unexpected.


From past data, we can see that the ratio does not peak until the peak of the hiking cycle or a few months after that. From Fed statements we can see that although the pace of hikes is expected to slow, a pivot is not expected anytime soon.


TRADE SET UP


To establish market neutral spread trade at inception, a ratio of 7:6 lots (DJI:SPX) is required with a long position on 7 lots of DJI and a short position on 6 lots of SPX. The ratio of 7:6 ensures that the exposure to DJI and SPX is neutral with equivalent notional on each position.


As such, 7 lots of Micro E-mini Dow Jones Average Futures March Expiry (MYMH2023) will be required which have a required margin of $750 each for a total of $5,250. Each contract of MYMH3 provides exposure to $0.5 x Dow Jones Index. Six (6) lots of Micro E-mini S&P 500 Futures March Expiry (MESH2023) will be required which have a required margin of $750 each for a total of $6,360. Each contract of MESH3 provides exposure to $5 x S&P 500 Index.


After factoring in margin credits, the anticipated total margin required for this trade is $12,000. The total notional for the trade would $120,000 SPX spread against $119,689 on DJI based on prices as of closing on 25/Nov.


This case study suggests entering the spread trade at the current DJI/SPX ratio of 8.522 with a target ratio of 8.671. This would yield profit of $2,140.


Where the trade is held to second target of 8.806 it would yield a profit of $4,054. In case the trade goes sour and the ratio contracts, we would exit the trade at the level of 8.236 which would result in a loss of $4,026. This leads to a reward to risk ratio of 0.53 for the first target and 1.01 for the second target.


SPREAD TRADE MARGIN
CME offers margin credits for spread trades. Clearing brokers might charge differently from the Exchange imposed margins.

MARKET DATA
CME Real-time Market Data help identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/gopro/

DISCLAIMER
Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.


This material has been published for general education and circulation only. It does not offer or solicit to buy or sell and does not address specific investment or risk management objectives, financial situation, or particular needs of any person.


Advice should be sought from a financial advisor regarding the suitability of any investment or risk management product before investing or adopting any investment or hedging strategies. Past performance is not indicative of the future performance.


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26 sty 2023

Transakcja zamknięta: osiągnięto wyznaczony cel

This trade reached its target ratio level of 8.671 on 28th December 2022. At that ratio the trade made a profit of $2,140 or ROIC of 17.8%.