Every trader knows the S&P 500 and the Dow Jones Industrial Average. However, one index is less popular but, at the same time, equally interesting as an investment opportunity. This guide will discuss the Russell 2000 index and examine the most popular way of investing and trading in this high-potential instrument – the E-mini Russell 2000 Futures (RTY).
The Russell 2000 was created in 1984 by the Frank Russell Company. Today it’s maintained by FTSE Russell, a subsidiary of the London Stock Exchange Group. The market-cap weighted index measures the performance of two thousand of the smallest-cap US companies. It’s a part of the broader index Russell 3000, which features the top American stocks by market cap. The index represents around 8% to 10% of the total market cap in the Russell 3000.
What is The E-mini Russell 2000 Futures Contract (RTY)
On July 10, 2017, the CME Group began offering the E-mini Russell 2000 Futures contract (ticker symbol RTY). The instrument has quickly become a popular choice for investors willing to get cost-efficient exposure to small-cap U.S. stocks. The list of people who trade the instrument includes both retail and institutional investors. Aside from being a healthy and highly liquid market, there are several other reasons for its prevalence.
For example, the E-mini Russell 2000 Futures contract allows market participants to hedge their macroeconomic exposure for a more stable performance. Aside from that, many traders consider it a suitable way to capitalize on expected market movements in the underlying index.
The E-mini Russell 2000 Futures Contract (RTY) is open for trading from Sunday through Friday (5:00 pm to 4:00 pm central time). Daily trading halts from 3:15 to 4:00 pm. A single futures contract trades in increments of 0.1 index points (1 tick = $5.00). One RTY contract has a value of $50 times the agreed-upon E-mini Russell 2000 Futures price. The E-mini Russell 2000 Futures contract expires every quarter.
E-mini Russell 2000 Futures (RTY) Contract Specifications
The schedule is set on the 3rd Fridays of March, June, September, and December. Here is an example of an RTY contract from the CME:
$50 x Russell 2000 Index
0.1 Index points
CME Globex: Sunday – Friday 6:00 p.m. – 5:00 p.m. Eastern Time (ET) with trading halt 4:15 p.m. – 4:30 p.m.
Five months in the March Quarterly Cycle (March, June, September, and December)
How to Trade The E-mini Russell 2000 Futures Contract (RTY)
If you plan on investing in E-mini Russell 2000 Futures, then there are some market-specific factors and key characteristics that can prove helpful for optimizing the performance of your portfolio. Make sure to consider the following five key things:
Index Components and the Characteristics of their Businesses
The fact that the Russell 2000 is made up of small-cap stocks means it is a highly dynamic instrument that can offer plenty of opportunities. What is typical for small-cap companies is that they are usually leaders in terms of innovation and growth. The small size of their operations grants them the flexibility to new regulations, changing market environments, chances to adopt new technologies and practices, etc. During market expansions and periods of economic growth, small companies tend to perform better and grow quicker.
A good indicator that helps confirm this is the P/E ratio, excluding dividends, which for the Russell 2000 stands at 26.75. Meanwhile, while for the S&P 500, it’s at 21.
It is also worth noting that smaller companies are more likely to be funded by credit, making them vulnerable to interest rate changes. Aside from that, small-caps are also more sensitive to labor costs and wage growth. This makes them a relatively risky bet in periods of bullish economic outlook.
When considering an investment opportunity, it is essential to look at its structure and, in the case of funds, its constituents.
The Russell 2000 is Dominated by Companies in Highly Dynamic Niches.
The main category is Financials (including banks and investment companies), followed by Health Care and Producer Durables. The fact that the companies representing these sectors are small-cap means they are more flexible and even aggressive when adopting innovative practices.
They realize the chance to grow their business by trying to make a “breakthrough” or, at least, to try forecasting the market’s needs and answering them in advance.
Small-cap stocks are usually domestic and closely aligned to the growing U.S. economy. The underlying index has a positive correlation to GDP, which is often observed and taken into account when making price predictions. As GDP grows, small-cap stocks tend to outperform their large-cap counterparts. On the other hand, the large caps have, in most cases, international operations and exposure to Europe and emerging markets and are less correlated to the US GDP.
The Advantages of Small-Cap Stocks
Data from Ibbotson Associates, for example, reveals that over the last 80 years, small-cap stocks have outperformed large-caps by over 2% per year. This is further confirmed by Robert Johnson, a finance professor from the Creighton University, who concluded that in the period 1966 –
2016, small-caps annual returns were estimated at 28.4% against 14.4% for large-caps.
Being more domestic has insulated small caps from trade tensions, geopolitical worries and the earnings drag stemming from a stronger dollar. Being less global also gives small caps more exposure to several positive factors in the US, including tax reform, increasing deregulation and faster economic growth relative to weaker recoveries in Europe and Japan.”
The fact that small-cap stocks service debt and acquire new capital easier in periods of low-interest rates explains why they outperform their large-cap counterparts in times of loosened monetary policy. Global trade wars and deteriorating international relations also favor small caps as they tend to make the most significant part of their revenue domestically.
Micro E-mini Russell 2000 Futures
In May 2019, the CME introduced the micro E-mini Russell 2000 futures (M2K). The contracts are 1/10th of the size of the RTY and replicate the movement of its bigger counterpart entirely. You can consider choosing the M2K if you are looking at low-cost opportunities but still want to take advantage of the growth potential of the US small-cap equity market.
In fact, the Micro E-mini futures contract proved to be a huge success, exceeding a volume of 32 million in its first three months. The instrument is favored by various traders as it allows long and short speculative opportunities over the Russell 2000.
A More Volatile Instrument
The fact that the Russell 2000 comprises small-cap stocks (willing to take more risks in their businesses) means it is exposed to higher volatility. If we compare the Russell 2000 and the Russell 1000 (an index tracking the top 1000 US companies by market cap), we will see that the volatility is much higher. The effect is multiplied in times of market turbulences like the 1987 market crash and economically stressed periods like 1990 – 1991, 2000 – 2001, and 2007 – 2009.
When the market instability slows down, the volatility also declines. For example, official data shows that, over the period 1979 – 2013, the average rolling 24-month volatility for the Russell 2000 is estimated at approximately 18.6%, while the one for the Russell 1000 is 14.4%.
This is something investors should keep in mind when going for the E-mini Russell 2000 Futures contracts. If you decide to invest in the instrument, keep track of the CBOE Russell 2000 Volatility Index (RVX).
The index measures the expected 30-day volatility of the Russell 2000 Index and can give you a new tool for monitoring volatility expectations in the U.S. small-cap market.
But how can the RVX help you? The volatility index may prove useful if you are trying to time the market and avoid concerns about buying at the top. Usually, a good entry time to go long on the Russell 2000 is when the RVX peaks. However, it is worth noting that the RVX alone can’t say much. If you want to better understand the upcoming market movements, make sure to combine it with momentum indicators like the RSI, for example.
RTY Futures Are More Suitable for Spread Trading
Investors in futures contracts buy them hoping that the price goes up, and sell them if they expect a decrease. In this regard, it’s no different from trading any other instrument. It is worth noting that many speculators trade futures mainly due to their suitability for spread trading. How does spread trading work on practice?
The E-mini Russell 2000 Futures, for example, are often used to take advantage of price discrepancies by taking long and short positions simultaneously. By having a buy and a sell order simultaneously, the trader hopes that the profit on the one end of the spread will exceed the losses on the other.
Types of Futures Spreads
To understand the strategy in detail, we should take a moment and focus on the different types of futures spreads. There are two main types of spreads– intra-market and inter-market.
As their name suggests, intra-market spreads are related to the same market/instrument. Intra-market spreads describe situations where the trader buys and sells the same underlying instrument (in this case, the E-mini Russell 2000 Futures contracts) but in different delivery months.
For example – an intra-market spread is when you go long on an E-mini Russell 2000 Futures in June and go short on the same instrument in December. The strategy’s main goal is to capitalize on the potential price discrepancies between the two delivery months.
On the other hand, inter-market spreads include the simultaneous trading of two different futures contracts like the E-mini Russell 2000 and the E-mini S&P 500. In this case, the trader tries to capitalize on the performance of large- and small-cap companies. If he is bullish on the performance of small-cap stocks, he will go long on the E-mini Russell 2000 Futures and go short on the E-mini S&P 500 Futures time.
Spread Trading In-Depth
Think of spread trading as a form of arbitrage. The trader tries to capitalize on the market’s structure and mechanics. Spread trading can prove successful in both bullish and bearish markets. You may wonder why you should go for both a short and a long position and suffer a guaranteed loss. Unfortunately, we are no Warren Buffets, and there is a chance you will struggle to time the market accurately.
That is why traders prefer spread trading. While not as profitable as sole long and short positions, spread trading reduces the risk significantly when they are successful. The chance that you will register a profit on either side of the spread is much higher when compared to trading outright a short or a long position.
Some traders also navigate between instruments covering small, mid, and large-cap stocks to increase their investment horizon and bring more opportunities to the table. The most preferred indices for the purpose are the Russell 2000, the S&P 400, and the S&P 500. The variety of combinations between those three indices allows traders to develop spread strategies, including buying and selling small- vs. large-cap stocks, mid- vs. large-cap stocks, and mid- vs. small-cap stocks. Here are some possible spread strategies according to the trader’s expectations:
Small caps outperforming large-cap stocks
Small caps outperforming mid-cap stocks
Large caps outperforming small-cap stocks
Midcaps outperforming small-cap stocks
An Appropriate Futures Spread Trading Strategy
First Combination: Long E-mini Russell 2000 & Short E-mini S&P 500
Second Combination: Long E-mini Russell 2000 & Short E-mini S&P Midcap 400
Third Combination: Long E-mini S&P 500 & Short E-mini Russell 2000
Fourth Combination: Long E-mini S&P Midcap 400 & Short E-mini Russell 2000
The different variations of the Russell 2000 can also be thrown into the mix. For example, you can construct a spread trading strategy, including the growth and value index modifications. If you think small-cap growth companies will outperform small-cap value stocks, then you can go long on the Russell 2000 Growth index and short on the Russell 2000 Value index.
However, if you plan on applying spread strategies, you should also consider the notional size of the separate index futures, as they may differ from each other. Oftentimes, to retain a more dollar-neutral position, you may be required to trade in a ratio like 2:1, for example (two RTY for one ES).
Can Be a Better Choice Than ETFs
What E-mini futures instruments and ETFs both have in common that they had been among the most popular and successful investible instruments for the last 25 years. Although there is no clear answer which one should you choose in the general case, the truth is that both have their pros and cons, depending on the situation, the type of investor, and his goals. However, the E-mini futures contracts have some clear advantages when compared to ETFs.
One is the lower commissions. Usually, futures contracts are much bigger in size. If we take the iShare Russell 2000 ETF (IWM), which is among the most popular ETFs tracking the index, and compare it with the E-mini Russell 2000 Futures contract, it becomes clear that the notional value of the latter is significantly higher.
The futures instrument’s notional value is close to $85 000 (multiplying the index value by $50), while the ETF is approximately $170. This means it will require close to 500 IWM contracts to equal one RTY, resulting in higher transaction costs.
In some cases, ETF instruments allow for after-hours trading. However, most of the time, they aren’t available 24/7. The futures contracts, on the other hand, can be traded over 22 hours per day. Even though the cash equity market is closed during a big part of the trading hours, futures contracts are still known for their excellent liquidity.
Another advantage of the RTY over IWM is the costs associated with the holding period. With the ETF, for example, you can hold the instrument in perpetuity. The RTY, on the other hand, has a fixed quarterly expiration cycle (March, June, September, and December). Although maintaining your futures positions throughout the year incurs some additional costs, it is way lower when compared to the 0.19% management fee of the IWM.
Taxation of Futures vs. ETFs
It is also worth considering the matter of taxation for both instruments. Here is an example – imagine that John fancies the E-mini Russell 2000 Futures instrument (RTY), while Mike prefers investing in the Russell 2000 ETF (IWM). Both have made profitable trades ($20,000 profit each) less than a year ago. The important thing here is, what will they take home at the end of the day? The answer is it depends on how both cases are treated from a tax standpoint.
The short-term gain of the ETF investor is taxed at an ordinary income rate. Futures traders at the time of writing this article were taxed as a section 1256 contract, which means they will have to pay 60/40 (long-/short-term rate). Depending on which tax bracket the investor is in, the difference might be staggering. In the top tax bracket, for example, ordinary income can take up to 39% of their profit. Meanwhile, in the case of the futures trading, 60% of the profit is treated as long-term capital gains and just 40% as ordinary income.
On average, this results in a tax rate of 28% – 30%. Depending on the size of the profit, the tax savings in the case of the futures investments may be significant.
Of course, it is worth it because the ETF, in this case, pays dividends, while the futures contract doesn’t. However, the futures prices are discounted so that they can reflect the lack of dividend payments.
You Should be Cautious in May and June
When investing in futures, it is crucial to always keep track of the situation with the underlying asset (in this case, the Russell 2000). The Russell indices are reconstituted in May and June each year. Over time, this process has become one of the most important factors for determining the investors’ interest in specific U.S. stocks. Around that time of the year, more advanced investors and funds base their trading strategies on the shifts within the indices by predicting which companies will be included and excluded.
As an investor in the E-mini Russell 2000 Futures, it is advisable to keep an eye on the index rebalancing. It usually results in increased demand for specific stocks and notable volatility. This will help you time the market and capitalize on its expected moves.
Russell Indices are Reconstituted Each Year
How can you predict included/excluded companies?
The primary determinant is market cap. The Russell 2000 consists of the bottom two-thirds of the Russell 3000.
Strong performance in mid-cap stocks will usually prevent shifts in promising small-cap stocks’ positions.
Value stocks are more likely to move between indices, while some growth stocks may be particularly vulnerable to being dropped due to their volatility.
Companies suffering from global macro volatility usually possess the highest risk of exclusion.
The same goes for basic materials and energy companies, as they rely heavily on raw materials for their operations, and global instability may harm their business.
But how can you predict which companies will become the new constituents and which will be excluded from the index? The primary determinant, of course, is market capitalization. As we mentioned above, the Russell 2000 consists of the bottom two-thirds of the Russell 3000 (approximately 10% of its total market cap) or the smallest securities. Aside from that, you should also bear in mind that strong performance in mid-cap stocks will usually prevent shifts in promising small-cap stocks’ positions.
Which Stocks are Selected?
As a rule of thumb, value stocks are more likely to move between indices, while some of the growth stocks may be particularly vulnerable to being dropped due to their volatility.
However, according to the Bank of America, growth companies usually trade at a premium compared to value-style stocks. Thanks to the bright economic outlook and loose monetary policy in the years after 2009, growth stocks have outperformed the value ones. So, in the end, it all comes to your investment preference and risk tolerance.
Investors should also keep in mind that companies suffering from global macro volatility usually possess the highest risk of exclusion. The same goes for basic materials and energy companies, as they rely heavily on raw materials for their operations, and global instability may harm their business.
Another thing that you should keep track of is trading activity and the general market sentiment. In bullish markets, most investors usually switch from large-cap to small-cap stocks as they seek ways to increase their beta and maximize returns.
Understanding the Russell 2000 Index
Large-cap funds usually compare their performance to the S&P 500, which is the most popular benchmark. In the case of small-cap mutual funds, the most popular benchmark is the Russell 2000. In this regard, the index is quite similar to other small-cap indices like the S&P 600. However, over time, the Russell 2000 has become the more popular choice among the broad investment audience, both as a benchmark and as a small-cap investment tool.
Unlike the DJIA, which is weighted by the full market cap of the included companies, the Russell 2000 index is weighted by shares outstanding. This means the index is influenced by the last sale prices and the number of shares available for trading for each constituent.
There are several varieties of the Russell 2000 index. First is the Russell 2000 Value Index, for example. It measures the performance of the constituents with lower Price-to-Book ratios and forecasted growth values. There’s also the Russell 2000 Growth Index. It reflects the performance of companies with higher P/B and higher projected growth values.
The Russell 2000 is a favorite among traders. It has proven to be the most accurate reflection of the profit opportunities presented by the entire sub-category of small-cap stocks on that market. Narrower indices, for example, may often contain biases or stock-specific risks that may distort the performance of the fund manager. That is why, over time, many funds have started offering investment instruments like ETFs or mutual funds that try to replicate the Russell 2000’s performance.
The index is also considered a vital sign for the health of the US economy because it reflects the performance of the smaller and domestically-oriented businesses.
Russell 2000 Performance By Year
Trading E-mini Russell 2000 Futures is an excellent choice for investors who want to capitalize on the potential of the often overlooked small-cap stocks. It also helps those who prefer to avoid the more expensive high-flying technology stocks and get better exposure to high-growth potential innovating companies in the field of finance, energy, and health care.
The Russell 2000-based instruments don’t possess notable company-specific concentration risks as the index isn’t dominated by any large-cap market leaders. The chance to choose between the E-mini and the Micro E-mini brings a much wider horizon to investors.
If you decide to invest in the E-mini Russell 2000 Futures, make sure to keep a close eye on the US macro and microeconomic situation as they affect small-cap companies the most.