SMALL CAP SWING STRATEGY

Trade small cap Russell 2000 index via ETFs

Summary

The goal of Small Cap Swing Strategy is to provide excessive returns using leveraged ETFs (exchange traded funds) as a proxy to the small cap index Russell 2000 price swings.

This strategy generates 2-3 signals per quarter based on market sentiment indicators, volatility and trend confirming/reversing patterns. Signals generated are fully algorithmic based on a quantitative methods. Strategy performance has been optimized in historical backtesting over different time periods and market conditions. As the name suggests often long position is followed by short one (inverse ETF) taking advantage of the price swings in the small cap universe.

Strategy results
This strategy is low turnover with indicative return based on backtesting is 40-70% p.a. Over the period 2019-2023 an investor would have turned 10’000 investment into 72,500 or 58% annualized return.



Backtesting & Performance

To ensure that strategy logic works in various market conditions a backtesting of the assumptions over 3 different periods has been performed. For the period 2008-2013 the backtesting starts with TNA inception back to November 2008, right in the midst of the Financial crisis. To ensure that there is no database or software bias backtests have been run on different platforms with independent databases. All tests gave relatively close results.

Performance
Over the period between 2014 and 2018 the Small Cap Swing strategy has generated 470% period return or 41.6% annualized compared to -19.7% period and -4.3% annualized return if investor simply buys and holds the underlying TNA. If one have followed this strategy over the mentioned 5 year period, between 2008 and 2013, total return would be 1283% or 77.2% annualized. The strategy generated 757% for the 2019 – 2022 period, 71.1% annualized.

Equity Growth 2019-2022

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Strategy risks
In order to control draw down risk the following risk mitigation techniques have been employed: Strategy does not use leverage - no use of margin. Every long position is opened with stop loss and take profit limits. During the test period maximal account drawdown was 45%. Investor should be able to accept considerable swings in his/her equity. Average position holding period is approx. 20 days.

Detailed description

Strategy logic
Small Cap Swing Strategy is an algorithmic trading system. It explores Russell 2000 index price patterns in order to generate excessive returns. Entry/exit signals are based on underlying instrument normalized volatility and periodic relative price performance. Whenever system criteria is met, it generates signal.

Small Cap Swing Strategy takes advantage of both directions of the market and focuses on short to mid term swing trading of Russell 2000 index trough long only positions in the follwoing pair of leveraged ETFs (Exchange Traded Funds) - Direxion daily TNA and Direxion daily TZA.

Why Russell2000 index?
Russel2000 index consists of the 2000 smallest US companies with size between $300M and $2B market cap. Most of them are domestic with higher grow potential than the large caps. According to several research papers, small cap stocks outperformed large cap over the last 90 years. Recent data published in the "Stocks, Bonds, Bills, Inflation (SBBI) Yearbook" shows that small-cap stocks returned 12.1 percent annually between 1926 and 2017 compared with large-cap stocks, which returned 10.2 percent annually during the same period. The reason for this outperformance could be explained with investors looking for high returns thus allocating capital in small stocks.

The Small Cap Advantage
The small cap size effect is one of the few widely accepted by nearly the whole academic community. It states that low capitalization stocks earn substantial premiums against stocks with large capitalization (without additional risk). This anomaly is the best described in the classical Fama and French research paper (1993).

The so called small cap premium leads the stocks with market cap between $300 mln to $2 billion outperforming large caps stocks. As a research from CME group shows, investors in this market segment could ensure considerable advantage, especially in certain phase of the market cycle.



Why using ETFs?
Direct investment in small, rapidly growing companies hides considerable risk for the average investor. In addition, most individual investors lack time or expertise to pick specific stocks like full time professionals do.

Diversification is another very important issue and it is one of the biggest problems for most individual investors as they simply cannot buy the whole market.

Exchange Traded Funds are instruments allowing investors to overcome one of their biggest disadvantages – size and diversification limitations. For relatively small sized portfolio in reality is difficult to gain broad market exposure as it can buy only limited number of companies. The advantage of investing in ETFs following indices is getting exposure to the whole market with relatively small investment, thus eliminating mentioned hurdles. Using ETF (Exchange Traded Fund), like TNA, gives individual investors the opportunity to gain exposure to portfolio of the 2000 smallest US stocks.

Why leveraged ETFs?
TNA and TZY are leveraged ETFs replicating 3x the daily performance of Russell 2000 index. TNA follows positive changes, while TZA is inversed i.e. rises with negative change of the underlying index by magnitude of 3.

Elevated daily changes of the leveraged ETFs provide a good profit opportunities which makes them most suitable instrument for the strategy goal – short term swing trading.

Why inversed ETFs?
Using inversed instrument allows investors to take advantage of the market drop without shorting any instrument and thus saving the cost of maintaining short position.

Small Caps Swing Strategy In Action