2016 started out as a challenging year for equity bulls. Then in early February, a few headlines triggered a massive rally led by small-cap stocks. The iShares Russell 2000 Index (ETF) (IWM), which invests in those small caps, rallied 17% off the lows, mainly fueled by an even more impressive rally in crude oil prices.
For perspective, though, realize that even after this massive rally, small caps still are in the red year-to-date. The IWM is off 4.5% for the year.
Click to Enlarge While I still think there is room for some upside, I believe we need vast improvements in fundamentals for markets to retry for new highs. So, in the absence of new positive headlines, 2016 will continue to challenge the equity bulls — especially anyone long on the Russell 2000.
I want to cautiously short this rally to set up mid-term trades that will yield easy rewards while leaving room for error. For this, I will use the IWM options market. Options strategies offer me hundreds of ways I can accomplish this. But I’ll stick to three.
3 Trades on the IWM
Trade No. 1 – The Short: Sell the Dec IWM $118 call. For this I collect $2.25 per contract. Potential yield is 12%. For this to be 100% successful, IWM would need to close below $118 per share by mid-December. I can modify this trade to make it a credit call spread instead so it would require less margin. I would instead sell the IWM Dec $119/$120 credit call spread. For this, I collect 25 cents per contract. This is a 30% potential yield and a 70% chance of success. Typically, I like better odds for success, but this trade comes after a 17% rally in the Russell 2000.
Trade No. 2 – The Hedge: Sell the Dec IWM $79 put. For this I collect an additional $1.30 per contract. Both trades together create a strangle of the small caps. For the strangle to be 100% successful, I need IWM to close between $79 and $118 per share. My breakeven levels are $75.45 and $121.55 per share. Like Trade No. 1, I can also modify this one to be a Dec $83/$82 credit put spread for a defined risk. For this, I would collect 13 cents per contract. The optional versions of trades No. 1 and No. 2 together would constitute an iron condor with 50% potential yield on money risked.
I am not a fan of selling naked puts, especially in markets that arguably are top-heavy. So, I could add a third trade to add a bearish short-term bias to the overall thesis.
Trade #3 – Put Spread: In addition to either versions of Trades #1 and 2, I buy an April IWM $101/$100 debit put spread. For this, I pay under 10 cents for a chance to profit 90 cents per contract if IWM falls under $100 in the next 24 days.
It is important to note that the IWM has technical patterns looming just above $111 that could ignite another rally that could bring the fund to $119 per share in the next few months. But fundamentally, I believe that May will bring seasonal and Federal Reserve rate hike headwinds.
Even though these trades are designed to be longer-term, I am not obliged to carry them through expiration. I can close any of these position for partial profit or loss.
Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities.
