New Trade – $IWM: Tip of the Small Cap?

by Dan October 16, 2015 12:12 pm • Commentary

On a couple of occasions this past week I have hit on the poor relative strength from the June highs to the August lows of small cap stocks measured by the Russell 2000 (for our purposes the IWM the etf that tracks the index).

From Wednesday’s MorningWord:  Russell – your looks are becoming a problem:

In case you missed it this past weekend, I was quoted in Barron’s The Striking Price column written by Steve SearsOptions Strategies for Bearish Investors. The column highlighted some large bearish options trades in the IWM, the Russell 200 etf last week, and I was asked to offer a hypothetical hedge in the small cap etf:

Dan Nathan, a trader who runs, likes “put spreads” on the iShares Russell 2000 ETF (ticker: IWM). That exchange-traded fund recently broke an uptrend in place since 2009, and is down 11%, to $115, since hitting an all-time high in June. “Protection below the recent low of $107 seems prudent, as there is little technical support below,” Nathan says in an e-mail.

INVESTORS WHO WANT TO HEDGE the IWM into year end can buy December $110 puts that expire Dec. 31 and sell December $95 puts with the same expiration date. The spread recently cost $2.35.

If IWM falls to $107.65, the put spread breaks even. If IWM is at $95 at expiration, the spread is worth $12.65.

I want to circle back and highlight why I chose the IWM as a potential portfolio hedge, as opposed to the SPY or the QQQ that track the S&P 500 and the Nasdaq 100 respectively.

The main reason for the IWM, is that small Cap stocks have shown poor relative strength to their large cap peers since the highs in the spring. The IWM, the Russell 2000 etf is down 12% from its all time highs made in late June, but importantly it’s the only major US equity index that has broken its August low. The IWM recently tested its uptrend that has been in place since its 2009 lows.

IWM 7 year chart from Bloomberg

While a bounce to $120 might be the ideal entry for a hedge, the fear of a re-test, and break of the Sept 29th low of $107 would mean a meaningful technical change for an index that had (until June) out-performed its large cap peers (it was up 280% from its 2009 lows vs SPY up 220% at 2015 highs).

But yesterday’s under-performance vs the SPY and the QQQ is exhibit-A why recent weakness may be the way to go when picking hedges with the best bang for your buck:

Oct 13th, 2015

Options prices in the IWM have come in hard of late. Following the late Sept vol spike 30 day at the money implied vol is 19% (down from Aug high of 32%). That seems cheap on a relative basis given the IWM’s beta to the SPY:

IWM 1yr chart 30 day atm iv from Bloomberg

Last week in this space (Bad Breadth Behind Those FANGs) I highlighted the concentration of a few stocks powering the performance of the Nasdaq 100, making the QQQ an attractive hedge for those with portfolios chock full of AMZN, FB and GOOGL. An IWM hedge makes sense for those looking for a cheap vol entry on an index that is likely to have larger moves on the next sell-off.

I want to revisit this idea as we have our most recent QQQ put trade rolling off with today’s options expiration and shift the exposure to the IWM. This works as either a straight short of the market or as a hedge vs a portfolio. Here is the trade:

IWM ($115.25) Bought Dec 18th 115/105 put spread for 2.50

-Buy to open 1 IWM Dec 115 put for 3.55

-Sell to open 1 IWM Dec 105 put at 1.05

Break-Even on Dec Expiration:

Profits: of up to 7.50 between 112.50 and 105, max gain of 7.50 at 105 or lower

Losses: up to 2.50 between 112.50 and 105 with max loss above 115  

Rationale:  See above, but in my opinion, the technical set up looks atrocious:

IWM 5 year chart from Bloomberg
IWM 5 year chart from Bloomberg