Hedge Hog – $IWM

by Dan June 10, 2016 2:49 pm • Commentary• Trade Ideas

Let’s talk small cap U.S. stocks for a moment. For the most part these are companies that have higher leverage ratios than their larger cap brethren, which in times of financial market distress like we saw in January and February, causes investor fear balance sheet risk. IWM,

We can see this effect by looking at he IWM (the etf that tracks the Russell 2000) which was the hardest hit U.S. equity index at its lows in early February, down 27.5% from its 52 week and all time highs made last Summer. Compare that to the S&P 500 (SPX) which had a peak to trough decline of just 15% and the Nasdaq Composite’s (CCMP), which had a decline of 19.5%.  From the February lows, the SPX & the CCMP are both up about 16%, while the IWM is up about 24%.

Basically, the IWM showed the worst relative strength on the way down, and had the sharpest rally on the way back up. That also means if this week’s U.S. equity decline turns into more of a sustained pullback or even a correction, then traders get the most bang for their buck using IWM as a hedge or short.  Also the IWM is the furthest from its 52 week highs, down about 10%, vs the SPX down about 2% and the CCMP down about 6%.  It’s my sense you pick on the index with the poorest relative strength from the all time highs for those looking to make a bearish directional bet.

A quick look at the one year chart shows what was a fairly impressive break and re-test of the downtrend, followed by the surge late last month that brought the IWM to new 2016 highs. To my eye another re-test of the downtrend just below $110 is quite reasonable on a pullback, and who knows what lies beneath:

IWM 1 year chart from Bloomberg
IWM 1 year chart from Bloomberg

If I were looking to a hedge a portfolio of U.S. stocks as we head into next week’s FOMC meeting and the Brexit vote in the UK the following week, I would do so with the IWM. I would also give myself some time for this to play out during Q2 earnings season in July, which will also catch the Fed’s July 27th meeting:

Portfolio hedge:

IWM ($116) Buy Aug 115/100 put spread for $3
  • Buy Aug 115 put for $3.75
  • Sell Aug 100 put at 75 cents

Break-Even on Aug expiration:

Profits: between 112 and 100 of up to 12, max gain of 12 below 100

Losses: up to 3 between 112 and 115, max loss of 3 above 115

Rationale – If the market fails here, the IWM is set-up for disproportionate backpeddling. It just tried to play catch-up to its larger cap brethren going from 108 to 118 in a straight line. With a breakeven at 112 this trade locks in protection for a pullback down to 110, and if a correction began to emerge it covers down to 100 in the IWM close to its lows of the year.