New Trade $IWM: Russell Your Looks Have Become A Problem

by Dan February 12, 2014 3:49 pm • Commentary

Yesterday we introduced a new portfolio hedge (here) in the SPY as we viewed the options in index among some of the cheapest of large U.S. equity indices where we could get near the money $10 wide spreads for 1/5 of the width.  We like that trade against a long equity portfolio, or as I chose to do as an outright bearish bet.

Today the price action in equities could mean different things to different investors.  A bull might think that we are getting a very healthy consolidation day after 4 days of quick gains.  One (like myself) might think that the rally is getting quite exhausted and this is a great spot to take some profits in longs, look for protection or take a shot for a retest in the coming weeks of last week’s lows.

Today I want to look at the IWM, the etf on the Russell 2000 index for 2 reasons.  First because the nature of its components should be more volatile than that of its large cap brethren, and second because it has shown poorer relative strength to the SPX and the technical set up looks quite weak.

The one year chart below shows the etf’s 8.5% peak to trough decline from the all time highs made on Jan 22nd, stopping almost on a dime at the November 2013 low, which also corresponds with the stock’s 150 day moving average (yellow line).  As most savvy technicians might have expected, the stock moved from support to resistance at the 50 day moving average (purple line), retracing about 50% of the decline culminating in this morning’s brief kiss of the momentum indicator before settling back.

IWM 1 year chart from Bloomberg
IWM 1 year chart from Bloomberg

It is our view that the rally is tired and we are likely to see a re-test of last week lows and possibly make lower in low as we get closer to the March 19th FOMC meeting as market participants will continue to debate the fate of the Fed’s Taper and likely contemplate the 3rd consecutive weak non-farm payrolls for Feb expected the first Friday of March.  

We want to start with a simple put spread purchase to make a defined risk bearish bet:

Trade: IWM ($112.35) Bought March 112/107 Put for 1.35

-Buy March 112 Put for 2.40

-Sell Match 107 Put at 1.05

Break-Even on March Expiration:

Profits: btwn 110.65 and 107, make up to 3.65, max gain of 3.65 at 107 or below

Losses: up to 1.40 bwtn 110.65 and 112, max loss of 1.35 above 112

Rationale:  We want to get near the money exposure with the chance of having a double if the stock were to re-trace back towards last week’s lows near 107.