The indiscriminate selling in small-cap stocks reached max velocity on Wednesday. Wall Street’s top small-cap ETF — iShares Russell 2000 Index ETF (IWM) – was off almost 4% at one point before rallying back a touch to close down 3.3%.
Worse yet, Thursday’s rousing rebound attempt was rejected like a Dikembe Mutombo stuff overnight, delivering a “hold-me-mommy” down gap Friday morning.
And with a three-day weekend looming, scaredy-cat investors may well continue panicking into the close. Thus far, any and all knife-catchers have had their hands sliced to pieces.
Liquidation knows no support in the heat of a panic. And yet, IWM is getting so ridiculously oversold at this point, and option prices in small-cap stocks so massively inflated, that the contrarian trade is looking mighty tempting.
To wit, the IWM ETF is now 23% off its highs, well into bear market territory. But more incredibly, it’s down 14% since Dec 30. That rate of decline is simply unsustainable.
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And as far as option prices go, the CBOE Volatility Index (VIX) tagged a new four-month high this morning at $30.95 signaling widespread panic.
It’s rare for the VIX to ascend to these heights and not see a sharp market rally in the ensuing days.
How to Trade IWM
One of the most attractive ways to position oneself for a rebound in small-cap stocks is selling bull put spreads in IWM.
Given the elevated implied volatility traders are able to sell far out-of-the-money IWM put spreads thereby creating a wide range of profit.
For example, you could sell the IWM Feb $89/$85 put spread for 40 cents. Provided the IWM doesn’t drop to $89 in the coming month the spread will expire worthless allowing you to pocket the 40 cent credit, which amounts to an 11.1% return. For the IWM to drop all the way to $89 the 23% correction would have to turn into a 31% one.
Given how far we’ve already dropped, I find that outcome highly unlikely in such a short period of time.
The risk is limited to the distance between strikes minus the net credit, or $3.60, and will be forfeited if the IWM ETF falls below $85 by expiration. To minimize the loss consider exiting if IWM falls to the short put strike of $89.
At the time of this writing Tyler Craig had no positions in any of the aforementioned securities.
