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CME Answers the Trader's Call with Sector-Related Products
by: David Lerman
In the world of market professionals, the S&P 500 index has long been the benchmark for measuring investment management performance and for quickly assessing the stock market overall. The Chicago Mercantile Exchange (CME), of course, brought this index into the futures arena in the early ‘80s, and the rest is history. During the first six months of this year, more than 11.2 million of the Standard S&P 500 futures were traded, and the one-fifth-size E-Mini S&P 500 futures contract chalked up a whopping 40 million contracts.
Seizing on yet another index-related opportunity, in late September the CME responded to a community of traders who for some time had been looking to the component sectors of the S&P 500 index as a way to focus on particular areas of the U.S. economy — sector-related products. Since Standard & Poor’s had classified the 500 companies in its composite index into industry-specific sectors and created indices based on those sectors, it was a natural extension for the Merc to introduce SPCTR™ futures contracts — translated: S&P Sector Index futures.
SPCTRS should give investors and traders an effective way to buy or sell any of the sectors that make up the overall index — with a single transaction. And, reflecting the ease and popularity of electronic trading, they are traded exclusively on CME’s GLOBEX® trading system. Any trader that’s been around since the late ‘90s will be familiar with GLOBEX because it’s the same system on which the E-Mini™ S&P500 futures and other contracts are now traded.
A Score of Sectors, Two Introduced
Under this new banner, ten sectors exist; however, the Telecom and Tech sectors are actually combined. Two of those sector indices have already kicked off for trading at the CME — the Technology/Telecom and Financials sectors, and the energy sector should begin trading before the end of the 2002. Others are planned to follow next year.
The indices are calculated using the same methodology and guiding principles that apply to all Standard & Poor’s indices. They are capitalization-weighted, with Technology representing 90 companies classified as part of either the Information Technology or Telecommunication Services sectors of the S&P 500. The Financial Sector Index is composed of 80 equities, and the Energy Sector Index is represented by 24 equities. Figure 1 highlights the S&P 500 and each of its component sectors.
Many of the sectors listed in Figure 1 have ETFs on the American Stock Exchange (Select Sector SPDRs) — some of which have generated positive interest. Technology, Financial and Energy sectors, though, have attracted the most attention in terms of volume.
For several years, futures traders have looked forward to the prospect of being able to trade futures contracts based on the various sectors of the economy. Those of us at the CME who have worked in the stock index products area for a number of years foresee the new SPCTR futures providing a broad array of additional trading strategies among the S&P 500 sectors once they take hold.
Playing the Sectors without a Major Portfolio Realignment
How can they be used, you ask? While two portfolio managers may have similar outlooks regarding the future of the stock market in general, they are less likely to agree on the direction of particular sectors of the market. One might be bullish on the tech sector while the other is bearish, and both are likely to be concerned with the performance of completely different sectors. In the past, money managers wishing to shift into and out of specific sectors could only do so via a major realignment of their portfolios. While the advent of sector mutual funds and computerized stock trading made such allocation shifts less complicated, with SPCTR futures these shifts will become even easier.
One of the benefits of trading SPCTR futures has to do with volatility and potential profit. Many sectors within the S&P 500 are more volatile than the index in its entirety. As Figure 2 shows, some sectors have reached 30 percent to 40 percent or higher volatilities on a regular basis while the S&P 500 Composite Index shows volatilities over the long run of between 20 percent and 25 percent.
All that said, let’s take this to the next logical step by outlining some sample strategies that might be used with SPCTRs. It’s a little too early in the game to get into detail as markets tend to produce new strategies as they develop, but the basics will speak volumes about the potential.
Tilt Strategies
Tilting or underweighting/overweighting a portfolio with regard to a particular sector is a commonly used strategy in institutional portfolio management. For example, a fund manager who is particularly bullish on the financial sector could overweight a portfolio using Financial SPCTR futures. Similarly, a manager who is bearish on financials and wants to decrease his exposure to that sector could use Financial SPCTR futures to make this adjustment quickly and cheaply and without a major realignment of holdings.
Spread, Cash Futures and ETF Arb Strategies
A primary benefit of Financial SPCTR futures is that they enable traders to implement long/short or spread strategies related to that sector. An investor who is bullish on the financial sector and bearish on the energy sector could use Financial SPCTR futures to take advantage of that outlook by combining a long Financial SPCTR futures contract with a simultaneous short position in Energy SPCTR futures.
Along with tilt and spreading strategies, the existence of Exchange Traded Funds (ETFs) on S&P 500 Sectors (Select Sector SPDRs®), and an underlying with very liquid large-cap stocks, creates numerous opportunities for cash-futures arbitrage and futures-ETF arbitrage.
Let’s look at two strategies an investor might utilize in his own portfolio.
Strategy 1—Tilting Strategy Using Financial SPCTR futures - Assume an investor is bullish on the S&P 500 but is bearish on the financials for various reasons - perhaps the potential for higher rates in the future. He wants to “own” the market but without the Financial sector and could use SPCTR futures to take advantage of this opinion.
Now, the financials comprise 21 percent of the S&P 500. If one S&P 500 contract is worth $225,000, then roughly $47,000 is dependent on the performance of the financial sector.
So, a trader would go long three S&P 500 futures (or 15 E-mini S&P 500 futures).
Value of three S&P 500 futures: $675,000
Weighting of Financials: $141,750 ($675k x 0.21)
Financial SPCTR notional value: $28,125
Number of FIN to short: $141,750/28,125
= 5 contacts
Remember that this is not a true spread, but merely a “tilting” (tilting away from financials) strategy. If the S&P goes down one percent and financials decline two percent, the financials would not only under-perform as thought, but the strategy would lose money overall. This strategy merely excises the financial sector exposure out of the overall index. The owner of $675,000 worth of S&P futures would see a $6,750 loss if there was a one-percent decline in the market. However, with the tilt strategy, the short FIN SPCTR position would provide $2,812 in profits, for an overall loss of $3,938 on the position — still a loss, but certainly one that is greatly mitigated by this strategy.
Strategy 2 - Using Technology SPCTR Futures -Let’s use the example of an investor with a $2,000,000 portfolio who has virtually no holdings in technology or telecommunications. He believes that the tech/telecom sector represents good value and wishes to boost his tech sector exposure to five percent of his holdings. He decides to increase his weighting in the sector by going long Technology SPCTR futures in order to quickly implement the strategy as well as to curb execution costs typically associated with major portfolio asset allocation shifts.
Hence, the investor would have to go long five Technology SPCTR contracts (TEC) in order to increase his exposure from zero to five percent ($0 to $100,000).
Number of Contracts to buy =
(final weighting – initial weighting) x value of portfolio
Technology SPCTR futures contract value
= (0.05 – 0.00) x $2,000,000 = $100,000
156.00 x $125 = $ 19,500
= 5.1 contracts
Although I’ve briefly mentioned only two possible trading strategies for consideration, there are a variety of strategic choices traders should also consider. After they become more familiar with SPCTR futures, they’ll no doubt develop some strategies of their own. But, in addition to trading strategies, Financial SPCTR futures provide other futures-related benefits. These are:
• They are traded in a single easy-to-execute contract, which makes the trading process easier than assembling and trading baskets of stocks;
• The transaction costs are generally lower than the costs of trading baskets of stocks;
• They generally require less up-front capital than that need ed for trading equities;
• They are cash settled to the Special Opening Quotation to their respective index, so there will be no physical delivery.
In conclusion, before you dismiss these futures contracts because you think they might be for gurus in the money management arena only, recall that the same thing was assumed in 1982 when the S&P 500 futures first began trading. Simply re-read the first paragraph of this piece to see how vigorously those instruments are traded by the individual investor today. And see how other newer products, like the SPCTRs, might fit nicely into your trading arsenal.