Stocks in Small-caps Are on a Rapid Rebound, Resulting in an Aggressive Bullish Trade

Small-cap U.S. stocks, which have been trailing their larger counterparts throughout the year, saw a robust surge of over 5% on Tuesday following October’s Consumer Price Index (CPI) data, indicating a faster-than-expected decline in inflation. I prefer using the iShares Russell 2000 ETF (IWM), designed to mirror the performance of the Russell 2000 index, which gauges the small-capitalization sector of the U.S. equity market.

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This lagging index experienced its most significant daily gain since November 2022, surpassing 6%. I am optimistic that this marks just the initial stage of small caps making a recovery.

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The struggles of small caps in comparison to larger peers stem from adverse effects in a rising interest rate environment, particularly impacting growth companies. The Russell 2000 ETF has finally entered positive territory in 2023, registering a modest 3% year-to-date increase. This contrasts with a 17% rise for the large-cap S&P 500 ETF (SPY) and an impressive 45% surge for the tech-heavy Nasdaq-100 ETF (QQQ).

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My belief in the resurgence of small caps is grounded in my recent forecast of U.S. Treasury yields easing. The notable 60-basis point decline in the 10-year yield (from 5.02% to 4.42%) has uniformly lowered borrowing costs for both consumers and smaller market-capitalized entities within the Russell 2000. (Note: 1 basis point equals 0.01%.)

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These reduced rates act as a catalyst for these oversold and overlooked companies, akin to rocket fuel propelling them forward.

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So, the question arises: will small caps sustain their recovery, or was this just a one-day spike? The answer hinges on U.S. Treasury yields remaining below their peaks and the expectation of the Federal Reserve maintaining a pause in the foreseeable future. Additionally, I have adjusted the exposure of my model portfolios to include small caps for the remaining six trading weeks of 2023.

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In terms of an option strategy, I plan to employ a zero-cost spread, commonly known as a risk reversal. In this instance, the call option's bid being higher than usual allows for a no-cost entry. While there is a risk of owning the underlying by potentially being assigned to the sold put, I am comfortable with this prospect given the nearly 20% difference in IWM and SPY from the market low in October 2022.

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The specifics of the risk reversal strategy for the iShares Russell 2000 ETF (IWM) involve selling a regular expiration December $175 put for $2.20 (slightly more than 2% lower than the Nov. 14 close) and simultaneously buying a regular expiration December $185 call for $2.20. The combination of selling the put and purchasing the call results in a zero-cost bullish spread.

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A risk reversal entails buying an out-of-the-money call and selling an out-of-the-money put, aiming for IWM to surpass the long call strike. While the upside potential is unlimited, there is also unlimited downside risk. This strategy allows for a bullish position with minimal upfront cash investment, financed by the sale of a downside put.

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In essence, this risk reversal serves as an aggressive bull trade. If my prediction of IWM continuing to rise holds true, the short put will become worthless, and the long call will appreciate, yielding a significant profit. However, if I am mistaken in anticipating the recovery of small caps, I will be obligated to purchase IWM at the short put strike price minus the premium collected, effectively owning IWM at $175. Despite the inherent risks, this outcome is preferable to outright purchasing the ETF at $179.