Tip of the Small Cap: $IWM

by CC March 24, 2016 11:53 am • Commentary• Trade Ideas

As the rally from the February lows started to get a little long in the tooth we tried to be patient in targeting sectors for a pullback from the recent highs, as they seemed to be extending each day amidst low volume and low volatility. We started focusing on small caps at first as the rally seemed to be incorporating a lot of dash for trash aspects as the SPX got above 2000. Here is what we had to say about the IWM (Russell 2000 etf) on March 7th when the SPX was 2000 and the IWM was 109-ish:

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?

We wanted to fade the relative strength in the IWM off the lows with the thought that if the entire rally got tired, the IWM would take a nap first. That’s sort of what’s happening now as the SPX is slightly higher from March 7th while the IWM is slightly lower (IWM red, SPX yellow):

Screen Shot 2016-03-24 at 11.32.08 AM
March 7th – present from LiveVol Pro

On that day we dd a fairly straight-forward trade in IWM looking for that pullback. Here was the trade and rationale:

*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

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.

Right now, with the IWM 106.40 this trade is worth about 4.80, so a slight profit but nothing spectacular, for that we’ll need a decline in the overall market that at least takes the SPX back below 2000. And at 2000 there could be support. And we have yet to see many signs of the volatility coming back into the market as most day to day moves remain < 1% for the time being. And if you notice we were already aware of the potential for low volatility to remain for some time and made sure we weren’t going fishing for out of the money options that could decay and become lotto tickets. In a post yesterday, I spoke about this defensive posture one must take with buying volatility during a potential vol hangover. Since we have yet to see many signs of that hangover ending we must stay vigilant on a trade like this. Right now with the IWM near 106 most of this trade is in the money and there’s not much extrinsic premium to be worried about, but any slow creeps towards 110 and we have to be very defensive. So for trade management purposes we’ll keep a short leash on lazy rallies and try to be patient on broader market declines.

On that theme, we got even more defensive on short term premium decay in a second IWM trade a few days later. In this trade the IWM had already started to stall but it was obvious it wasn’t going to be a sharp pullback so we looked to sell near term premium to finance puts out in September and give some time to the thesis. Here was the trade:

*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

With IWM just over a dollar lower at 106.40 this is worth about 3.60. So nothing much has changed. But remember this is looking all the way out to September so near term we’re not looking for fireworks. A slow pullback is just fine for this trade. And the market going sideways isn’t a big deal either. If the market continues its low vol chop sideways we’ll just continue to roll out the short call strike in order to finance the September puts.

So both trades are looking for a pullback in IWM without owning too much extrinsic premium. But they’ll need to be managed individually due to their differing time horizons.