Traders are making bullish bets on U.S. small-cap stocks, even though these stocks have struggled to outperform large-caps over the past year. Rising expectations of Federal Reserve rate cuts are prompting investors to view small- and mid-cap companies—which stand to benefit from lower borrowing costs—more favorably.

Data shows the Russell 2000 Index surged 8.5% over the five trading days ending last Friday, bringing its year-to-date gain to 12.12%, meaning this rally contributed over 70% of its annual advance. Open interest in call options for the iShares Russell 2000 ETF, the largest fund tracking the index, has risen to its highest level since September relative to put options, signaling optimism that the rebound will continue.

Christopher Jacobson, co-head of derivatives strategy at Susquehanna International Group, noted in a client report: "After being battered earlier by more hawkish rate-cut expectations, small-caps have become primary beneficiaries of the recent dovish shift." Russell 2000 components, which rely heavily on short-term borrowing, are particularly sensitive to interest rate movements.

Fed officials' remarks last week reignited market expectations for a December rate cut. According to CME Group's FedWatch Tool, traders now assign an 87.6% probability to a 25-basis-point cut this month, up sharply from just 30% on November 19. Speculation about a more dovish Fed chair appointment under a potential Trump administration next year has further buoyed small-caps.

Meanwhile, declining relative costs for Russell 2000 call options have made bullish bets more attractive. With reduced demand for downside protection, the call skew—a measure of expensive upside bets—remains low, creating opportunities for investors.

Compiled data reveals one trader paid approximately $1.4 million in premiums on Tuesday for call options betting the iShares Russell 2000 ETF would rise above $255 by December 12—just 2.5% above Friday's close. Another trader wagered on an 8% gain by February next year.

"From short-dated December calls to longer-term structures, bullish positioning is building across multiple expirations," observed Chris Murphy, Susquehanna's co-head of derivatives strategy.

Jonathan Krinsky, BTIG's chief market technician, believes small-caps' recent breakout is "more likely to sustain." Morgan Stanley's chief U.S. equity strategist Michael Wilson noted last week that despite recent pullbacks in high-momentum growth stocks, current weakness may signal improved intermediate-term prospects. He upgraded small-caps and consumer discretionary sectors to overweight, citing resilient earnings revisions and "the most pronounced upward inflection" in forward revenue estimates among small-caps.

Historical data supports the bullish case. Bespoke Investment Group found that after the Russell 2000's three consecutive 1.5%+ daily gains through last Tuesday—a pattern seen 19 times previously—the index typically delivered above-average returns over 3-, 6-, and 12-month periods.

Still, small-caps continue to lag large-caps. The Russell 2000's 12.12% YTD gain trails the S&P 500's 16.45% advance. If small-caps underperform again this year, it would mark a fifth straight year of trailing large-caps—matching the 1990s record for longest underperformance streak.