REAL WORLD

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Profit In Puget Sound?

The Russell Reconstitution: Plan For 2008

by Don Bright

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Are there still profit-making opportunities in the Russell 2000? Find out here.

There has been a lot of discussion about the "Russell reconstitution" and whether there would still be a good profit opportunity for professional traders. Some have opined the "edge is gone," but I am here to say, "No, it isn't." I have hundreds of traders, many of whom made excellent money using various strategies, all focusing on this event.

RECONSTITUTION

First off, here's a basic description of what we're talking about. Each stock market index is composed of individual stocks. The Dow Jones Industrial Average (DJIA) has only 30 stocks, and the Standard & Poor's 500 holds 500, obviously. The Russell 2000 is made up of 2,000 small- to medium-capitalization companies (1,001st through the 3,000th largest domestic stocks as judged by market capitalization). The reconstitution is simply the replacement of certain stocks with others. You have "adds" and "takeouts." The most recent replacement day was June 22, 2007.

The reasoning behind the concern about making profits was based on the fact that the stocks being swapped are known well in advance of the actual event. This is not the case with the S&P 500 (they use a closed approach). This knowledge leads to what is referred to as "front-running" -- buying the adds and shorting the takeouts ahead of the event. Bright Trading had traders who did, in fact, begin their trading weeks ahead of the June 22nd date. Our people tended to close most positions ahead of June 22 profitably and then take a clean slate for the actual event. Simply knowing the new composition of stocks ahead of time is not enough to guarantee profits ("guarantee" is a tough word to use in this business anyway), but when combined with some market savvy, access to enough capital (via professional capital-use capabilities), our traders did very well.

A CHANGE IN TREND

Why did our early group make money? This is due in large part to increased liquidity in these issues. When a good trader sees an obvious change in trends of these particular stocks, they can play these trends with a noncorrelated-pair strategy. The stocks being taken out are generally the weaker stocks and vice versa for the stocks being added. Being able to take home these currently stronger stocks, in several layers, offers them the ability to "ride the wave" of the moving average convergence/divergence (MACD) and just plain divergence.

...Continued in the March issue of Technical Analysis of STOCKS & COMMODITIES

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Excerpted from an article originally published in the March 2008 issue of Technical Analysis of
STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2008, Technical Analysis, Inc.

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