Name That Trade – $IWM: Don’t Sweat the Smaller Things

by Dan December 11, 2014 12:36 pm • Commentary

There has been a lot written about the under-performance of the small cap Russell 2000 Index (up 1% ytd) to that of its large cap brethren the S&P500 (up 11% ytd) in 2014.  On more than a few occasions we have taken some trading cues from that underpformance, but heading into year end the Index’s consolidation just below the prior highs is fairly intriguing in what could be a market that has the potential to close up near the highs of the year.

The one year chart below of the IWM (the Russell 2000 etf) shows that the index has basically traded in a fairly tight sideways range for most of the year between $110 and $120:

IWM 1yr chart from Bloomberg
IWM 1yr chart from Bloomberg

It is important to note that the IWM has had 4 peak to trough declines that have equaled about 10% on average, which is considerably higher than the average peak to trough declines in the SPY of about 6.25% during the same periods. Investors are understandably less bullish on the prospects for small caps when economic fears take center stage.

Options prices reflect this sentiment, with 30 day at the money implied vol in the IWM at about 18% vs 13% for the SPY. The December 31st quarterly 117 straddle is about $4, which basically means the options market is pricing in a range that takes the IWM either to new breakout highs above the previous high of $120 or to what would be a slight breakdown below recent consolidation (but still at or above the 50 day moving average of about $113.50).

The next and possibly last real scheduled catalyst for U.S. equities in 2014 will be the FOMC’s Dec 17th meeting where many expect the Fed to drop the term “considerable time” as it relates to rate increases.  Could we be in for one more bout of volatility if this were to occur?

For those looking to play for a catch up rally in the IWM to the prior highs at about $121 made on July 1st by year end, the Dec 31st quarterly 117/121/125 Call Butterfly for $1.25 (stock ref $117.15) looks like an attractive defined risk way to play, limiting your risk to less than 1% of the underlying stock price, with a break-even less than 1% higher with max gain of 2.75 at $121.

We are not bullish on the index into 2015 but it could easily close on the highs of the year if this consolidation holds. With that in mind this would be the structure we’d use if we wanted to play for that.