Bears Send a Shot Across the Bow

by Tyler Craig | April 2, 2013 8:53 am

Spurred by a weaker-than-expected ISM manufacturing report, Monday’s trading session kicked off with some early-morning profit-taking. Though the Dow Jones Industrial Average remained largely unchanged by day’s end, small caps weren’t so lucky.

The Russell 2000 registered one of its worst days of the year, falling 1.34%. What’s more, the liquidation came with heavy volume, indicating aggressive institutional selling. Year-to-date, Monday’s downturn was the largest distribution day we’ve seen in the Russell.

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Aside from the excessive volume, the selling deluge caused two other bearish developments of note. First, the iShares Russell 2000 Index Fund (NYSE:IWM[1]) closed below its 20-day moving average for the first time in a month. Second, the recent underperformance in small caps has led to a trend reversal in the comparative relative strength of IWM vs. the broader market.

As shown in the bottom panel of the accompanying chart, the ratio of IWM:SPY had been rising ever since the autumn bottom in mid-November. This rising ratio denotes leadership by small caps, which is a positive omen for stocks as it reflects more aggressive behavior by traders.

With the recent break of the trend line (red arrow), small caps have changed their stripes from market leaders to market laggards. Continued weakness in the little guys should concern the bulls.

Lest we blow Monday out of proportion, though, remember that all previous signs of weakness have been quickly shrugged off by our resilient bull market. Time will tell whether yesterday was a one-off event or the start of a more serious correction.

Whether you believe Monday was just the tip of the iceberg or that further upside in small caps will be limited, bear call spreads are worth a look.

With the Russell 2000 currently trading at 936, you could sell the May 980-990 call spread for $1.60 credit. Consider it a bet that the Russell won’t rise above 980 by May expiration. The max reward is limited to the initial $1.60 and the max risk is limited to the distance between strikes minus the net credit, or $8.40.

If you want to keep a tight leash on the trade, you could exit if the RUT breaks above resistance at $955.

As of this writing, Tyler Craig owned neutral option positions on the Russell 2000 Index.

  1. IWM:

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