The Small Cap Vs. Large Cap Trade
- rickstine
- May 1, 2023
- 2 min read
Over the weekend, Rebecca Patterson, the former CIO of Bridgewater Associates, made the argument in the Financial Times that small cap stocks will continue to lag their large cap brethren for two reasons: If interest rates move higher, small companies will have to refinance debt at higher costs. And because small cap companies tend to rely more heavily on bank loans, the recent collapse of a handful of regional banks will likely make small cap company access to loans more difficult.
So, we decided to take a look at possible trading scenarios between the two sectors using Excalibur Pro's pair-trading tool.
We looked at the S&P 500 and the Russell 2000 Index (but of course you can use the ETFs that represent each). We set up the same trading period (from Jan. 2 of this year through April 28). And we used the same "triggers" for each of the three strategies (enter at 2 or -2, and exit at 1.75 and -1.75.) Interestingly, the Cointegration trade and the Correlation trades had exactly the same results, so, we are showing just one of those graphs (correlation). The distance trade was quite different.
As you can see from the graphs below, the top graph in example is showing you the daily values of the triggers. As those values continue to rise significantly above or below the "enter" trigger, the trade becomes much less profitable and can turn into a loss. So, when we track these trades, it is important to monitor that trajectory. The graph below the "trigger" graph shows the actual and annual returns.
We also attached a spreadsheet that shows the returns (you can easily download spreadsheets from Excalibur Pro with this data.) We cut and paste the fields that we wanted to compare from the respective spreadsheets to create this one. What's notable is that for a handful of trades, they turned negative the day after they were entered. The faint-of-heart would have exited. For those willing to take an extra day or two to see how the trades would fare, they turned positive. The graphs show returns if you kept on the trade from "enter" to "exit" as defined by the "triggers." But you can obviously exit at whatever point you feel you have reached your level of comfort.
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