An Option Bet That Wins if Small Caps Rally Following a Possible Rate Cut by the Fed

The S&P 500 logged its 19th record high of 2025 on Thursday, just one day before the release of the Fed’s preferred inflation measure, the Personal Consumption Expenditures (PCE) Index, which came in right on target for July.

‍

This marks the first significant economic test for the Federal Reserve since Chair Jerome Powell hinted at the possibility of an interest rate cut at the upcoming September meeting.

‍

Small-Cap Stocks Take the Spotlight

With this backdrop, I see an opportunity to leverage the recent surge in small-cap stocks to capture additional upside compared to other major U.S. indices.

‍

To do this, I’m targeting options on the iShares Russell 2000 ETF (IWM) a move aimed at benefiting from any extended rally in sectors poised to gain from rate cuts.

‍

The Russell 2000 Index, which tracks small-cap U.S. equities, has been outperforming other benchmarks since last Friday following Powell’s dovish tone.

‍

August has been especially strong for small caps, which have climbed nearly 10% so far this month, fueling speculation that this long-underperforming index may finally be staging a comeback.

‍

For context, small caps have trailed all major U.S. equity indices over the last three years, according to YCharts.

‍

Why Small Caps Could Keep Running

Now that the Fed’s rate-cutting cycle appears to be back on track after almost a year-long pause, small-cap stocks could have room to run into the year’s final stretch.

‍

While these companies tend to be more volatile than the large-cap names that dominate the S&P 500, that volatility often translates into higher reward potential for investors willing to embrace the risk.

‍

It’s worth noting that the all-time high for IWM sits at $244.98, and my strategy assumes that a fresh record could be set this fall.

‍

The Trade Setup

Here’s how I’ve structured the position:

• Buy the IWM $236 Call (expiring 9/30/25) for $5.85
• Sell the IWM $250 Call (expiring 9/30/25) for $1.25

‍

This creates a debit call spread costing $4.60 per share, or $460 per one-lot contract. At the time the trade was initiated, IWM was trading around $236. For this spread to break even by expiration, IWM needs to close above $240.

‍

Investor Takeaway

The recent strength in small caps, combined with the Fed’s dovish tilt, makes this a compelling setup for traders seeking targeted exposure ahead of potential policy shifts. If rate cuts materialize as expected, small-cap stocks and by extension, IWM could continue to lead gains into year-end.

‍