$IWM In a RUT

On Tuesday we detailed a bearish long premium directional trade idea in the IWM, the etf that tracks the Russell 2000, the small cap U.S. index (read here).  Here was our view about the current volatility environment, and why we think the IWM could be the single best U.S. equity index target from the short side as we exit a fun filled week and a half of Central Bank meetings next Wednesday:

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%.

As we head into the end of a volatile week on an up note, I would mention that the IWM is basically flat on the week vs the SPX up nearly 1%.  In the prior post I highlighted the relative performance of the IWM vs the SPX over the last year, but I’ll refresh:

The Russell 2000 (RTY) declined 27% from its all time high in late June to its recent lows in February, it has since rallied 15%

The S&P 500 (SPX) declined 15% from its May highs to its February lows, but has since rallied 11%.

Small caps massively under-performed on the downside, but has not shown commensurate out-performance on the upside from the lows.

While the SPX is now at its 200 day moving average for the first time this year, the RTY is still 6% below.

IWM is probably a great place to get the most bang for your short buck as a portfolio hedge or an outright bearish bet.

While the bounce off of the Feb lows is impressive, it could be running out of steam. A look at the 8 year chart off of the financial crisis lows shows a long term chart pattern that I think is worth betting against. Having broken the long term uptrend, and now attempting to re-take.  Entry on the short side is tricky though, as the chart shows obvious resistance a bit higher closer to its 200 day moving average:

Timing is crucial for long premium directional trades and our May put spread is betting on the rally running out of steam soon. But there’s another way to look at things if you aren’t interested in trying to time the end of this rally as much as looking for an ongoing trend to play out over the Summer months. After a period of such extreme volatility, into some highly anticipated events, we could be due for some calm.  Traders looking out months from now may want to look to finance longer dated bearish bets. Here is a way to do it in the IWM, targeting Summer fireworks and an important technical level at $100. For those who agree with thesis, and like the idea of whittling away at out of the money put premium over a series of 6 months, this is one way to do it:

*TRADE: IWM ($107.50) Buy April / Sept 100 Put Calendar for $3.50

• Sell 1 April 100 put at 75 cents
• Buy 1 Sept 100 Put for 4.25

Break-Even on April Expiration:

-Max gain at $100, down 7.5%

Rationale – The main idea here is to finance longer dated downside puts, if we get to April exp and stock has moved lower we will look to turn into a calendar again, or possibly a vertical in Sept.