Want to turn a little bit of money into a lot? Catch a turn in the market. Alas, it's also one of the hardest things to pull off, which is why it is widely considered to be a legendary feat -- one that is much harder than simply riding momentum, which is one of the stock and options markets' predominant trades.
But the potential payoff of catching market turns is huge -- and the best place to look for the best ideas is by combing through what's unpopular. Catching turns requires advanced analytical rigor and tradecraft, and something that makes most investors very uncomfortable: a belief that you are right and everyone else is wrong.
Such contrarian thinking is starting to gurgle around small-cap stocks and their proxy, the iShares Russell 2000 exchange-traded fund. After a torrid first half, the ETF is down 9.3% since mid-August, when investors began flocking to the safety of large-cap stocks and hot artificial-intelligence trades as sentiment soured on small-caps. Investors have repositioned to larger stocks as the 10-year Treasury yield remains above 5%.
More recently, though, options trading patterns suggest some bold investors think small-cap stocks have fallen too far -- and this is leading to some nascent bullish activity.
The bullish small-cap thesis is simple. If corporate earnings season, which began this week, is better than expected, and if management teams are more optimistic about the financial future, investors will want to broaden their market exposure. Also, any hint that the Federal Reserve might hesitate to raise interest rates would likely spark a relief rally, as small companies are more vulnerable to rising debt expenses.
Still, the small-cap ETF's numbers are looking grim. At $276.70, IWM is below its 200-day simple moving average of $277.31. When stocks fall below this long-term trend line, many institutional investors consider it "dead money" that's unlikely to advance. Even more dire, IWM is also below is 20-, 50-, and 100-day moving averages, which means the ETF must overcome some serious hurdles to regain its upward momentum.
At least October, one of the most volatile months of the trading year, tends to favor small-cap stocks. Chris Jacobson, a Susquehanna Financial Group strategist, advised clients that IWM's October rebounds average about 1.8%. He flagged late-October call-option spreads as a low-cost wager on a relief rally. (Calls give holders the right to buy an asset at a set price within a specific period.)
If this intrigues you, consider buying IWM's October $283 call and selling the October $293 call, which both expire on Oct. 30. The call spread -- buying one call and selling another with a higher strike but the same expiration -- costs about $1.68. At $293, the spread's maximum profit is $8.32 -- an extraordinary return if the thesis plays out. During the past 52 weeks, the ETF has ranged from $228.90 to $305.18.
The spread's implied volatility is about 16.9%, signaling that IWM will move a little more than 1% each day until expiration. By contrast, the implied volatility of the large-cap State Street SPDR S&P 500 ETF's Oct. 30 call is only about 10.5%, suggesting a daily move of about 0.65%.
Options volatility synthesizes art and science, and it changes, often dramatically, in response to events. Should the Fed fail to raise interest rates on Oct. 28, IWM could rally, and volatility would likely decline. The opposite is true if rates rise, or the Fed signals that it's likely to at future meetings.
Capturing market turns is hard. The best way to do it is to use options to define risk and position for powerful returns.
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