I know you already know this, but the Russell 2000 severely lagged the S&P500 (SPX) in 2014 (up only 3.5% vs its large cap brethren up 11.5%). I know that you also already know that while the SPX marched to new high after new high in 2014, closing at the very highs on the last tick of the year, the Russell 2000, as measured by the IWM for our purposes seemed trapped in a fairly tight trading range for most of 2014, spending most of its time between $110 and $120. There were no shortage of market pundits who labeled this under-performance as a sure sign the broad market was topping. Well, once again the index is threatening a breakout, and if and when it does, the move could be fairly epic! A breakout of the Russell would show a healthy broadening out of the bull market. Will the 4th attempt in a year at new all time highs be the one?
I think it is important to note that put volume over the last month has been on average 2x that of calls. 14 of the top 15 strikes of open interest are all puts, with all of the put strikes below 115 making me think they were longer standing bearish bets or protection. While options prices are down from a bit from the recent highs, there remains a healthy bit of skew towards puts suggesting that traders are more concerned with a breakdown than a breakout. Which could make directional options strategies to take advantage of this relationship attractive for those looking to play for a breakout.
BUT HERE IS THE THING, WHILE THE TECHNICAL SET UP LOOKS ATTRACTIVE, THE INDEX HAS FAILED TO BREAKOUT IN EACH PRIOR ATTEMPT, AND EACH FAILURE HAS BEEN MARKED WITH PULL-BACKS OF 3-5% AT LEAST OVER THE LAST YEAR. SO USING OPTIONS IS MORE ATTRACTIVE THEN BUYING STOCK HERE.
HYPOTHETICAL TRADE: IWM ($120.50) Buy March 115 / 123 Risk Reversal for .30
-Sell to open 1 March 115 put at 1.17
-Buy to open 1 March 123 call for 1.47
Break-Even on March Expiration:
Profits: above 115.30
Losses: of up to 30 cents between 123 and 123.30, losses of 30 cents between 123 and 115, put stock at 115 and lose 30 cents premium with unlimited risk like stock below.
Rationale: The break-even on the upside is 2.3%, while risking 30 cents between a wide range of 115 and 123 (or 6.5%) while worst case scenario is being put the stock down 4.5%. The trade’s large profit potential on expiration (excluding the premium outlay) is skewed to the upside, making put sales an attractive vehicle to finance upside calls, getting more bang for your buck.
Of course, that doesn’t come without risk as the short put isn’t that far out of the money.
As for the levels, at the money calls don’t exactly seem like a great way to play, and the rising 200 day moving average, just below the double bottom low from January seems like a decent spot for a limited order, which is essentially the short put strike.
At this point I’d rather play for single stock breakouts than that of a broad index, I think you get more bang for your buck, but this set up looks attractive for those that think the rally broadens out and want to participate with options rather than stock.