$IWM: Russell – your looks are becoming a problem

by Dan March 7, 2016 3:45 pm • Commentary• Trade Ideas

The rally in the S&P 500 (SPX) from last month’s lows near 1800 to today at 2000 was initially powered by some of the most loved and most prominently weighted in the index. But of late it has broadened out to some fairly unloved sectors like energy, materials, miners, transports and heavy machinery.  There is a full on short squeeze going on in some spaces. What were fears just a few weeks ago of lower for longer commodity prices leading to some sort of credit event in emerging markets has now turned into a fear of missing out on all the sectors in the middle of that scare. Oil and other commodities have rallied sharply, some highly levered companies have raised equity (MRO), others have gotten some respite on debt loads (PBR) and the potential for high profile bankruptcies appear to be shelved for the time being (CHK, FCX).

The gazillion dollar question is whether or not the recent bounce is predicated on anything fundamental, or merely a sentiment shift that has lead to an epic short squeeze. Frankly I have no idea, but the trader in me says that if you didn’t have the stones to buy some of these stocks/sectors a month ago when things looked dire, but are piling in here up 50 to 100% because you like the momentum, you’re probably doing it wrong.  Albeit, that from a guy who wouldn’t have bought some of these stocks with Trump’s money last month.

With the extended bounce of the lows and the rotation to some of the higher vol/ beaten up stocks has come a reduction in overall option premium in the market. For a broad look, check out Spot VIX:

VIX 6 month chart from Bloomberg
VIX 6 month chart from Bloomberg

This is where things get tricky for options trading. The SPX is now hovering around 2000 into three fairly important central bank meetings over the next week (ECB March 10th, BOJ March 15th & FOMC March 16).  If there are no surprises out of these meetings, could we be pinned to 2000 for a bit?  What often happens after a spike in volatility is the period immediately following it comes to a standstill near important psychological levels with a vol compression an immediate result. The reason for that is a lot of options get bought for both protection and as lotto tickets after a sharp selloff. On the reversal from those lows there is a fear of getting stuck with rotting premium so a lot of scalping starts to happens (selling as stocks go higher and buying as they go lower) as well as a lot of options selling. The difficulty for options trading is knowing when it’s safe to get back in the water during that compression in vol.

If there is a revisit in volatility soon, it’s likely to be over represented in small cap U.S. stocks, as measured by the IWM, the etf that tracks the Russell 2000.  The IWM has rallied about 16% from its February lows, and is now only down about 4.5% on the year, but still down about 15% from its all time highs made last Spring.  The IWM’s peak to trough decline over the last year was about 27%:

From Bloomberg
From Bloomberg

For comparison sake, the SPY’s (let’s use this to compare vs IWM) peak to trough draw-down from last Spring to last month was about 15%, it is now up 10% from the recent lows, and only down 1.7% on the year.  This sounds about right when you consider the credit differential between large and small cap stocks, but I would add that its apparent that the IWM’s under-performance on the way down was more pronounced than its bounce off of the lows vs the SPY.

For those that think the rally in U.S. stocks is coming to an end, and are considering shorts, you may get the most bang for your buck in the IWM.  Of all the major U.S. stock indices, the IWM was the first to break its long term uptrend off of its 2008 lows, and remains below it.  Playing for a failure at the uptrend, which was long term support, now resistance could be a high probability play from here:

IWM 8 year chart from Bloomberg
IWM 8 year chart from Bloomberg

Short dated options prices have come in hard in the last month, with 30 day at the money implied volatility at 18.65% vs a recent high above 30% and vs 30 day realized volatility at 22.5%, options prices seem at least fair, to possibly cheap considering the recent move, and the upcoming macro events:

From Bloomberg
From Bloomberg

So what’s the trade?

With options prices low, the etf approaching huge technical resistance, the IWM could set up for an attractive short entry, or a portfolio hedge:

*IWM ($109) Buy the May 110/90 put spread for $4
  • Buy 1 May 110 put for $4.50
  • Sell 1 May 90 put at .50

Breakevens on May expiration:

Profits – up to 16 between 106 and 90 with max gain below

Losses – up to 4 between 106 and 110, with max loss of 4 above $110

Rationale – This entry benefits from low implied vol after the market rally and near a potential inflection point where the rally could fail.  We think in the money puts make sense if in fact the etf were to spend some time around current levels.