The compression in volatility so far in 2012 has been well-documented, and is equally intuitive if we note the vertical leaps that equities have made. See the narrowing trading range in the CBOE Volatility Index (CBOE:VIX) on the daily chart below; should the VIX break back above the 20 mark, things may get more interesting again.
At the same time small caps, as measured by the iShares Russell 2000 ETF (NYSE:IWM) are up around 11% year-to-date, more or less in a straight shot. And, in terms of its slope, it has gone vertical recently.
Overbought tapes like these can remain so for an extended period of time. Yet with volatility at current levels – when, just a few weeks ago, sentiment was overly pessimistic – it seems overdone.
Both the beauty and the curse of using options as a trading vehicle is that, depending on the strategy used, one has to get both time and price right in order to end up with respectable profits. The current situation specifically in the Russell 2000, however, is setting up such that an eventual increase in volatility coupled with a price correction should reward put buyers well.
I see an initial long position in May puts in the IWM (slightly out-of-the-money) as a good risk/reward setup, both either as a portfolio hedge or an outright position. (With the IWM trading at $82.81, puts at the $82 strike and lower are out-of-the-money.)