Small-Caps Look Due for a Stumble

by Tyler Craig | September 4, 2013 11:26 am

Small-Caps Look Due for a Stumble

The smaller the are, the harder they fall.

We’re starting to see a slight shift in focus from the increasingly confident bears as the market pullback enters its fifth week. Thus far the large-cap Dow Jones Industrial Average has led the weakness, dropping well below its 50-day moving average and coming much closer to the pivotal June support level. In comparison its fellow index brethren — the S&P 500, Nasdaq Composite and Russell 2000 — sit well above the June low, exhibiting relative strength versus the Dow.

IWMresistance 300x219 Small Caps Look Due for a Stumble[1]

And yet, in recent days small-caps have revealed a growing number of bearish developments. First, sellers are sitting heavy atop the Russell, squashing every rally attempt in small-caps by flooding the market with supply. Since the large down gap last Tuesday, the iShares Russell 2000 ETF (IWM[2]) has tried no fewer than three times to get back above resistance at $102.40, but to no avail.

Second, the intraday action in small-caps over the past few weeks has traced a head-and-shoulders pattern. This ominous formation reveals a shift in the balance of power from bulls to bears — and if completed will signal more downside to come. Completion and confirmation of the pattern will occur on a successful break of neckline support in the $100.50.

(To their credit, the bulls aren’t giving up without a fight. The last two attempts to breach the neckline were successfully rejected.)

IWMHS 300x219 Small Caps Look Due for a Stumble[3]

If you’re looking for more downside in the ongoing stock swoon, consider entering bear call spreads on the Russell 2000 once the aforementioned head-and-shoulders pattern is completed with a break of the neckline. You could enter the October 1070-1080 bear call spread by selling the October 1070 call and buying the October 1080 call for a net credit around $2.20.

The max reward is limited to the initial credit received and will be captured provided the small-cap index remains below 1070 by expiration. (Though the current credit offered is $2.20, if you wait until the neckline is broken the net credit will be less.) On the flipside, the max loss is limited to the distance between strikes minus the net credit and will be incurred if the RUT sits above 1080 at expiration.

To reduce the risk, you could exit if the head-and-shoulders pattern is invalidated with a break above the right shoulder or head.

At the time of this writing Tyler Craig owned shares of an S&P 500 ETF.

Endnotes:
  1. [Image]: http://investorplace.com/wp-content/uploads/2013/09/IWMresistance.png
  2. IWM: http://studio-5.financialcontent.com/investplace/quote?Symbol=IWM
  3. [Image]: http://investorplace.com/wp-content/uploads/2013/09/IWMHS.png

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