Small Caps: Left Behind No Longer

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Since the Fed’s rate cut last week, the market has tanked… not so much because of the cut. That was already priced in and expected. In fact, it looked like it might give stocks a little stability, at least in the short term. But then came new tariffs.

President Trump announced sweeping new tariffs on the final $300 billion worth of Chinese goods that had previously been off the table. Investors have been unsurprisingly unhappy about that.

Again, it’s impossible to know exactly where all of this will lead. While investors don’t like the idea of additional taxes on imports and disrupted supply chains, consumers are split about their opinions on them.

Consumer confidence hasn’t drastically changed these past few months of intense Chinese negotiations. And it isn’t likely to. The only thing that has changed is how larger companies need to deal with them to secure their margins.

As these multinationals continue to flounder over how to avoid paying 10% to 25% more on anything from China – from raw goods to manufactured ones – another group has been hurt even more.

Small cap companies, those with far fewer important relationships with Chinese goods, have been struggling for quite a while.

Here, you can see that the Russell 2000 (black) – an index made up of mostly small companies – has significantly lagged the larger S&P 500 (blue) over the last year… especially over the last six months:

Screen Shot 2019-08-05 at 10.24.56 AM.png

The rationale, at least the seeming rationale, for this is that if the economy does slide, small companies get hit first. Last summer was a perfect example. Small caps fell far quicker than the rest of the market did in the last four months of 2018.

However, with a responsive Fed, consumer sentiment stability and the dollar finding its footing, the economy might just flatline for a period. Large caps, might go in either direction. But small caps… they are positioned to shrink those performance margins.

A year-end rebound is likely. You see, the Chinese tariffs will impact some small cap companies. But they are far less intertwined with the global marketplace than their larger peers. They operate far more domestically than the rest of the S&P 500.

Moreover, with the Fed cutting rates, borrowing might ease. That allows small companies to expand once again. That could have a powerful short-term effect.

So, a near-term bounce for the Russell 2000 is definitely in sights. One way to play it would be to simply buy shares of the iShares Russell 2000 ETF (IWM). It tracks the performance of the index.

But a far better way, and one that risks far less capital, yet can produce even greater returns, is through a specific options strategy we often use around here for short term bullish investments.

Let’s get into it.

A Specific Strategy For Short Term Bulls

A bull call spread is a type of options trade that involves buying one near-the-money call option on a stock you believe will rise in the near term and selling a second call with a higher strike price.

The income received from the sold call helps offset the cost of the purchased one. This reduces both the amount at risk and the potential profit. You can see how that looks here:


Source: The Options Industry Council

While it is never ideal to reduce the amount any trade can bring in, for a play like IWM, it makes sense. After all, even if small caps do far outperform their large cap peers, it’s doubtful they’ll skyrocket too much in the next few weeks and months.

More likely, a moderate bounce is in the cards. So, a reduced cost/risk approach with a still high enough potential return is the best way to play it. And in this case, that’s exactly what we have.

Let’s look at a specific example a trader could get in on today…

A Specific Trade on IWM

Right now, a trader could buy a September 20 $155 IWM call for $3.05 per share and sell a September 20 $160 call for $1.10 per share for a cost of $1.95 per share. Since each represent 100 shares of IWM, that’s a net debit of $195.

That’s the total amount at risk for the duration of this trade – about seven weeks. The trader would only lose that if shares of the Russell 2000 ETF don’t bounce as expected.

However, if they do, even just a little bit, the profit potential is much larger. To find that, take the difference in strike prices ($160 – $155 = $5), and subtract the cost ($5 – $1.95 = $3.05). Or, on 100 shares, that equals a maximum profit potential of $305.

In other words, this trader would be looking at a return of 156% on the amount at risk. That is, of course, if shares do rebound upwards of $160 by September 20.

That represents a price movement of 5% from today’s prices. Considering the gap between the two major groups – large caps vs. small caps – is far larger over the last year’s worth of performance, a jump of that amount is quite small.

Small cap stocks have underperformed their larger peers by 12.1% since this time last year. It would only take a small bounce for the trader to see his full profit potential on this play.

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