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Market Dynamics Behind Index Spreads:
An Opportunity For Hedge Funds

by Howard Simons, NQLX's Special Academic Advisor.

Different stock indices, whether broad- or narrow- based, by definition have different characteristics. These include different volatilities, different factor exposures and different industry exposures. Since these differences persist over time, trending spreads between two indices are quite common.

Many of these spreads display the characteristics of embedded options. An embedded option is a financial instrument with asymmetric returns. These are quite common in the world of commodities. The refining margin for heating oil, shown below, is an excellent example of an embedded call option. Its value can increase quickly and sharply, but it seldom falls below a floor level.

A second view of this spread's distribution underscores its characteristics as a call option. We can create a histogram of the spread's distribution and compare it to an expected Gaussian (normal) outcome. Values in excess of the expectation are realizations of the embedded call option's value.>

Applications For Stock Index Spreads
The weights of the top 20 stocks in the NASDAQ 100 (NDX) and their comparative weights in the NASDAQ Composite are listed below. In late January 2002, the same stocks constituting 54.6% of the NDX account for only 40.6% of the Composite. This alone can produce a trending spread between the two indices. If we add an overwhelming market direction to the picture, either up or down, the mechanics of indexation could push the trend even further.

NASDAQ Weights

NDX (100) Composite

Microsoft Corp 10.59% 11.24%

Intel Corp 7.09% 7.42%

Cisco Systems Inc 4.46% 4.56%

Qualcomm Inc. 3.72% 1.12%

Oracle Corp 3.53% 3.13%

Amgen Inc 2.50% 1.96%

Dell Computer Corp 2.41% 2.40%

Maxim Integrated Products 2.24% 0.59%

Immunex Corp 1.91% 0.51%

Siebel Systems Inc 1.79% 0.55%

Veritas Software Corp 1.65% 0.58%

Applied Materials Inc 1.58% 1.12%

Xilinx Inc 1.58% 0.43%

Linear Technology Corp 1.52% 0.42%

Concord EFS Inc 1.47% 0.46%

Sun Microsystems Inc 1.43% 1.21%

Comcast Corp 1.43% 1.07%

Peoplesoft Inc 1.36% 0.34%

WorldCom Inc 1.18% 1.17%

Genzyme Corp 1.16% 0.31%

The long bull market in technology stocks made the spread trade of being long the NDX against the Composite a winner from the mid-1980s until early 2000. Once the spread between the Composite and the NDX was more than 60% of the Composite's value; this advantage nearly disappeared by December 2000. By late January 2002, it returned to 19.6%.

Persistent trends and embedded calls are only one of the many applications CTAs and hedge funds are likely to find for futures on stocks and on narrowly-based indices. Other applications, such as matched pair and alpha trades, are discussed elsewhere on this Website.

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