Trade the FTSE 100/250 spread

mwpt

Hi,

Is there a way for an amateur investor to take up a short position against the FTSE 250? The only investing I've done previously has been in equities for dividends as an alternative to 0% interest rates. I have done ok with this but I am interested in the following scenario:

FTSE 250 index has vastly outperformed the FTSE 100 index over the last 10 years or so but I note that on the previous downturn the FTSE 250 lost more value than the FTSE 100. I'm interested to know how I can take a long term bet on this spread narrowing at some point? What are the mechanics of such a trade, do I have to make regular margin calls if it goes against me, etc. Admit, I'm completely clueless how it would work.

tg99

You could open up a spread betting account with someone like IG Index and go long FTSE 250 index and short FTSE 100 index (I have done this quite a few times in the past myself between different indices). However, I would be careful if you've not used spread betting or traded derivatives before and make sure you fully understand how it works - perhaps start with a demo account - as there are plenty of amateur investors who have become a cropper when spread betting (e.g. in getting themselves too leveraged). That said, used correctly it can be a good way of achieving exposure to certain themes like the one you have mentioned above and also in hedging various risks in your physical portfolio. And yes you would be on call for margin if the position moves against you and remember that both sides of the trade could move against you so be careful about how much notional exposure you take. Also if it is a long term bet you will pay a spread each time to roll over the contract into the next one etc.

mwpt

Thank you, I missed this response. Good thing I didn't take up that position, the spread has continued to widen during the downturn, so I would have been pretty wrong!

mwpt

But still, there is something there imo. 2008 saw the spread narrow, but apart from that it's been widening since inception. Longer term trade might be there, depending on costs.

bowlhead99

If I'm following your thought process - you're looking to make money off the idea that what goes up must come down, so although the 250 generally goes up up and away from the 100, it will eventually get reined in.

What you're observing is that as a general rule, the mix of "medium sized" companies in the 250 grow their capital values faster than the leviathans in the 100... except when they don't because there's a downturn, at which point they will fall harder and faster.

There are a few factors at work there but basically a key one is that the type of company that has already grown to £100 billion in size and dominates the FTSE100 - a massive bank, oil or pharma company- is not a company positioned to rapidly grow its profit levels and market share. The top five companies in the 100 have a combined market cap of about 400 billion, which is more than all the companies in the 250 together.

So common sense would dictate that over time, the big plodders would be outpaced by the cheeky young whippersnappers. Another characteristic when you're looking at the capital value of the index rather than total return, is that the current big plodders are also throwing out a larger level of dividends rather than internally reinvesting. Throwing out the cash to investors will knock down the capital value because the money is no longer in the company.

By contrast when we hit a recession or worsening market sentiment, as a generalisation the large slow moving companies with steady boring profits and dividends will often not get dumped as hard as the fast moving smaller ones. So the MCX line starts to drop back towards the UKX - both are falling but the smaller more volatile ones fall faster.

So as a generalisation, yes there might be "still something there" in that MCX will grow away from UKX and then at times start to head back towards it. But the logic above would say that the times MCX does relatively worse is going to be the times the market is down generally. Hence, rather than betting on the difference between the two indexes getting smaller, you could just bet that one of the index would go down.

Of course sometimes the gaps do widen while markets are going down - as you'd have felt if you'd placed your bet on it narrowing - because the mix of the largecaps is skewed to certain sectors. Markets dropping because giant oil companies are hit by low oil price and giant commodities companies are hit by lower demand for their metals from China, will hurt the 100 more than the 250 which has more of a domestic focus and lower oil and resources. And by contrast, if there's a big financial services and resources-led bull market, that would (relatively) favour the 100, meaning that relatively speaking the 250 might not grow as fast as it does in a broader market movement and not open up such a big gap, if any.

Because of that (the different sector mix) and the fact that different sectors shine at different times, it stands to reason that each index will have its "time in the sun" and you would expect gaps to narrow as performance "reverts to mean". But the size factor and the fact that bigger companies are more likely to be ex-growth, means that smaller companies are *generally* going to diverge positively and over the long long term will not get dragged back to parity with large ones.