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The cage HAS TO be bigger then the highpoly model. And yes, the low and high poly MUST be in the same place.
Here is how normal maps works:
Let's take a simple example with a plane and a bump. The lowpoly is a plane, the high poly is a plane with a bump in it. When you make the cage you have to be sure that it is bigger then the highpoly. Here is why:
When the normal map is generated, 3dsmax "measures" the distance between the lowpoly and the highpoly model and it builds a map that represents that difference. In our planes, on the edge, the highpoly and the lowpoly are the same.... they are different just where the bump is. So at the edge the normla map will be the neutral color. In the bump area the distance between the lowpoly and the highpoly is marked on the map by a change of color. The vertex in the moddle of the lowpoly is lower then the one on the highpoly, because it is on the bump. The cage tells the program where to look, and it looks inside the cage. If the cage is smaller in some areas then the highpoly model is the verteces that are outside the cage won't be take into account... this is when you will see red spots on the image that is displayed in the rendering window.
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