At a Glance
- Sometimes overshadowed in futures markets, the Dow may be the best equity index for trading dollar sensitivity.
- E-mini or Micro E-mini futures could help smooth out risk as the Dow’s largest component, Boeing, sees extreme volatility
CME Group lists four main equity contracts. Each contract offers different exposure to the U.S market. The S & P 500 is the broadest view with its blend of large cap ,mid cap and small cap stocks. The Nasdaq 100 is, of course, heavily rooted in technology. The Russell 2000 is weighted more toward smaller companies. The Dow 30 is weighted toward the largest U.S. companies.
Historically, the E-mini S & P and the E-mini Nasdaq have been the leaders in volume and liquidity.The Dow 30 index is in third place based on liquidity and volume but still is a highly liquid product. Most traders have a love/hate relationship with the Dow 30. On one hand it’s only 30 stocks. How can 30 stocks give an accurate glimpse of the entire U.S. market? Despite its limited scope, it persistently remains the average investor and news outlets’ “go-to” measure of U.S. equities. More sophisticated traders still use the Dow 30 for a couple of interesting reasons as well.
The Dow and Dollar Strength
The Dow is more sensitive to fluctuations in the dollar compared to the other indexes. The theory is that larger U.S. companies have greater global reach and a higher volume of transactions conducted in foreign currencies. If we look at the equity rally that began on December 24, 2018, it suggests that this theory holds true. In this time period the Dow futures rallied 23 percent while the S & P gained 27 percent. One reason for the small relative underperformance may be the concurrent dollar strength.
I will readily admit that the relationship between the Dow and the dollar is far more evident when the dollar has broken out of a trend and making significant moves. The relationship compared to other indexes is also somewhat difficult to measure because of the inherent increased volatility of price swings in the smaller stocks. In other words, a pairs trade would have to be weighted heavier toward Dow in order to smooth out volatility.
Big Events, Financials and Manufacturing
One intention I have is to use Dow futures, alone or as part of a pairs trade, to express different dollar-related themes. For example, If I start to believe that Brexit will be resolved gently, I would expect that the Euro would benefit at the expense of the dollar. The resultant dollar weakness could fuel a disproportionate strength in the Dow index relative to S & P or the Nasdaq. If I acted on this thesis I would buy Dow futures and sell S & P 500 futures. The combination of E-mini contracts and the new Micro E-minis would allow a trader to achieve the exact ratio desired and allow for the ability to add to a trade or take profits with greater precision.
Although the Dow is not as sector top-heavy as the Nasdaq, some sectors have significant representation. Financials represent 16 percent of the Dow 30, the largest of any of the indexes. If you believed that your portfolio was sensitive to risks surrounding bank earnings, hedging using Dow futures would be a reasonable strategy. The same would hold true for industrial and manufacturing companies which make up 20 percent of the Dow.
Trading on Big Names
The Dow’s largest component is Boeing. Boeing stock had a period of extreme volatility in February and March as it dealt with an enormous software issue that had catastrophic results. Another use of Dow futures could be to smooth out risks associated with possible additional headlines or earnings in a heavily represented stock like Boeing. The same would hold true for other big Dow names like Apple or Goldman Sachs.
The point is that as we get more specific in our futures trading we can use different characteristics of the various indexes to accurately represent a particular thesis.