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Dollar’s Strength Delivers Outperformance to Small-Cap Stocks (IWM)

Play the relative strength breakout in small cap stocks


Of all the crosscurrents flowing on Wall Street the most important trend these days has to be the ascension of the U.S. dollar. The greenback’s rise has reached the parabolic stage where its upward trajectory has gone vertical.

dollar bill washington money 630
Source: Flickr

Whether this is destined to become a blow-off top or is simply the bull market kicking it into high gear remains to be seen. One thing is for certain, the buck’s relentless rise is sending ripples throughout the financial sphere.

One of the common themes accompanying periods of prolonged strength by the mighty dollar is weakness in big companies selling their wares abroad — multinationals, as they say. Overseas sales don’t translate into as much profits with the U.S. dollar now perched at a 12-year high.

In contrast to the elevated sensitivity to a rising dollar in big multinationals, smaller, domestic companies are largely insulated from the ongoing reign of strength in the kingpin of currencies.

So how have small-cap stocks been faring relative to their big-cap brethren? For that we look to a ratio of the iShares Russell 2000 Index (ETF) (NYSEARCA:IWM) and SPDR S&P 500 ETF Trust (NYSEARCA:SPY). The IWM ETF represents small caps while the SPY represents large caps.

When the ratio line is rising, small-cap stocks are outperforming; when the line is falling, large-cap stocks are outperforming.


The accompanying chart reveals three things of note:

  1. The IWM:SPY ratio recently staged a strong breakout showing definitive relative strength from small caps.
  2. The newfound strength in small caps has occurred during a strong rise in the dollar (the gray area chart in background), which certainly supports the idea that dollar strength favors small-cap stocks over large cap.
  3. The study in the bottom panel displays the correlation between the IWM:SPY ratio and the dollar. While the relationship between the two has been all over the map during the past few years, the correlation currently sits at 0.92, which is the strongest positive correlation we’ve seen in years.  In other words, the recent rally in the dollar has arguably aided in the relative strength breakout for small-cap stocks.

An Option Trade for the Little Guys

Traders expecting continued strength out of small caps can position themselves to profit with options in IWM. If you want a high probability of profit consider selling the Apr $117/$113 put spread for 52 cents credit.

The maximum reward is limited to the initial 52-cent credit and will be captured if IWM can remain above $117.

The maximum risk is limited to the distance between strikes minus the 52-cent credit and will be lost if IWM falls below $113.

At the time of this writing Tyler Craig owned neutral option positions on the Russell 2000.

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