The Rocking Russell 2000: A Better Day-Trading Market Than the S&Ps?

THE PHRASE "DAY TRADER" may carry a negative connotation for market participants these days. Implicit in this impression is that many think of day traders as the villains who first created, then burst the Internet stock bubble. But today's day traders are a different sort who are not likely to grab headlines for huge profits betting on tech stocks.

Many of today's new day traders increasingly are using futures instead of stocks, and they're using E-mini futures in particular, some heading for the E-mini arcades in a quest for success. To say that S&P 500 futures and its E-mini S&P futures brethren (at one-fifth the value) are the backbone of day trading would be a colossal understatement. Together, their daily trading volumes average close to one million contracts per day (actual 2005 average = 891,000 per day through July 20, 2005).

To grasp just how much money underlies these markets every day, just look at the notional value being traded. Each S&P contract has a notional value of $250 times the value of the index, with the E-minis at $50 times the value of the index. Through July of this year, the average daily price of both S&P index futures products has been right around 1,200, or about $62 billion notional.

It then would stand to reason that among the hundreds of day-trading systems I have seen in my career and the few dozen we trade for clients, at least 90% have been S&P-based systems.

However, there is another market also catching the eye of many day traders — E-mini Russell futures. A quick glance at the top trading systems we ranked across seven different statistical measures at the end of 2004 showed something extraordinary — several E-mini Russell trading systems occupying spots at the top of the list.

We also highlighted the viability of trading the Russell 2000 futures in an April 2004 newsletter, mentioning the impressive run the E-mini Russell made as it went from trading volume of less than 1,000 contracts a day in 2002 to more than 42,000 contracts daily in March 2004. Since then, trading volume has nearly tripled and is on pace for an average daily volume of just more than 115,000 contracts in 2005. Clearly, this volume explosion (see Chart 1 and Chart 2) has created some new opportunities for market participants.

It also sheds light on the lack of opportunities elsewhere — narrowing ranges in U.S. stock index markets. The average daily range of the Nasdaq-100 futures in 2001 was greater than 150 points, but since has dropped 87% to a 2005 average daily range of just 21 points. The S&P futures have a similar look, as the average daily range so far in 2005 is 56% less than it was in 2001 — at just 11 points per day versus more than 27 points in 2001.

For those who think these may be unfair comparisons due to the high volatility during the Internet bubble bursting in 2001, think again. We compared the current average daily ranges with those of 2004 and found that they continue to decline. The average daily range has fallen another 21% in the Nasdaq and another nine% in the S&P futures over the past year.

This is exactly what all the talk in the business news is about — historically low volatility As is clear from these statistics, the number of points the U.S. stock indexes move in a day is becoming smaller and smaller. When was the last time the Dow was up or down more than 200 points? Most market participants simply can't remember. Is the cause precipitated by a move out of stocks or is it the trillion dollars in hedge fund investments all chasing the same returns? Whatever the cause, the shrinking volatility is making the profit opportunities in the S&P and NASDAQ markets smaller and smaller.

With the profit opportunities in the S&P day-trading market getting smaller and smaller, sophisticated investors are searching for other opportunities.

Using the Effective Range
Here's one quick and easy tool for measuring the profit opportunities in different markets — it's a measure called the "effective range."

To understand the effective range, consider the S&P futures with their average daily range of just more than ten points per day. Buying the bottom of that range and selling the top would net an investor approximately $2,500. We call this value the effective range. The effective range simply is the maximum amount of dollars possible to extract, on average, from a particular market. It is calculated by multiplying the average daily range by the contract value. For example, a 20-point average daily range in the Nasdaq-100 futures produces an effective range of $2,000 (20 points x $100/pt).

Considering effective ranges from a day-trading system standpoint, a system cannot realistically expect to make 100% of the daily range on one trade. Many investors would be ecstatic if their systems could generate just 50% of the daily range. Consequently, it is in trading-system investors' best interests to seek out those markets with the highest effective ranges; no matter what percentage of that range their system makes, the dollar gain is larger.

So what index futures market has the highest effective range? You guessed it — the Russell 2000 futures. At $500 a point for the full-sized contract and $100 for the E-mini Russell, the effective range has averaged $4,400 in 2005, or nearly double that of the S&P futures with an average effective range of $2,900 so far this year. Meanwhile, the Nasdaq-100 futures have gone from the highest effective range of these three U.S. stock indexes in 2001 at over $15,000 down to a miniscule $2,100 in 2005 (see Chart 3).

With the range of the Russell and S&P having been virtually equal over much of the past year — both averaging daily ranges of about ten points — the math becomes very easy to understand. If there is a ten-point move in each market, the trader stands to make (or lose) double the money trading the Russell because the value of a point in the Russell ($500) is double what a point is worth in the S&P ($250).

Thus, a trading system utilizing the Russell instead of the S&P can afford to be less precise in its entry and exit, while still making the same amount of money on a winning trade. Again, though, this also means a trader could lose the same amount of money on a much smaller move. But, in essence, the higher effective range means traders don't have to peg the high and low of the day to make a decent return.

Russell on the Move
The Russell 2000 index was developed by the Frank Russell Co. and is designed to track the performance of a set group of companies similar to the S&P 500 index. Unlike the S&P 500 that tracks the largest 500 companies in the U.S., the Russell 2000 is a much broader index, measuring performance of the smallest 2,000 companies inside of the Russell 3,000 index, which then logically tracks the largest 3,000 companies domestically.

The Russell 2000, of course, is considered a small-cap index, measuring small-cap stocks in two categories — growth and value. The average market capitalization in the index is about $1 billion, compared with an average market cap in the S&P 500 index of roughly $20 billion.

Russell reconstitutes its indexes annually unlike some others index providers, which often can mean a more accurate, timely depiction of the market. Interestingly, thanks to annual reconstitution, Microsoft and Starbucks were added to the Russell 1000 seven years before they were included in the S&P 500.

Though the Russell has been around for quite some time, it only recently burst onto center stage in the futures arena. One reason for this sudden prominence was a sparkling performance during 2003. During that year, the index was up more than 47%. Compare that with gains of just less than 30% in the S&P 500 — still substantial, but not up to the Russell's level. Subsequent periods, though they cannot match 2003, still are impressive — in 2004, the Russell posted gains of 18%, and thus far in 2005, there's been a four-percent increase. When compared against S&P returns of nine% in 2004 and just more than one% so far in 2005, the Russell stands atop the heap.

With the reputation as one of the best-performing major indexes has come volume from institutions, hedge funds, individual investors, and most recently, trading systems. A new survey measuring market share of various stock index families showed Russell's family of U.S. indexes hold an industry-leading 52-percent share of the institutional market for benchmarks. The survey also found 49.5% of the $3.8 trillion in assets represented in the survey now are benchmarked to Russell indexes and, in terms of institutional usage Russell indexes represent nine of the top ten. The small-cap Russell 2000 Index continues to rank as the second-most commonly used equity benchmark in the U.S.

Will Russell Be King?
Will the Russell take the place of the S&P as the index futures market? Though it has made tremendous strides and currently brings traders opportunities they cannot find elsewhere, the chance of overtaking the S&P is fairly remote. Or, at least, don't count on it happening any time soon. The full-sized Russell contract averages just more than 2,200 contracts changing hands daily, and S&P E-mini volume still dwarfs the Russell E-mini volume, at nearly 830,000 contracts per day versus approximately 120,000. Yet growth in the Russell has been nothing short of spectacular, showing that traders are moving away from dwindling opportunities in the S&P into the expanding ones in the E-mini Russell.

For traders inclined to use trading systems, E-mini Russell-based trading systems may be one way to gain exposure to that market. Trading systems can be as simple as suggesting a buy at tomorrow's open while risking only three points, or as complex as a neural net using artificial intelligence to gauge market sentiment. Their real value, however, may lie in their ability to make an investor's trading decisions consistent.

A number of trading system developers have been looking in on the Russell for quite some time now, but many systems utilizing the Russell did so only on a swing-trading basis. Day-trading systems developers now are getting in on the Russell act, too. A short list of top Russell systems is listed is Table 1.

Take some time to study the Russell futures products in the current market environment. Steadily increased trading volume bolsters the liquidity situation so traders can get in and out of the market with ease. Clearly, too, their effective range is something that gives them a leg up on other indexes that might previously have been a more popular choice.