Traders See More Upside Ahead for the Risky Small-Cap Rally

Investors are increasingly placing optimistic bets on small-cap stocks, even though these companies have consistently lagged behind their larger counterparts over the past year. The shift in sentiment is gaining momentum as expectations grow that the Federal Reserve is nearing a cycle of interest-rate cuts an environment that historically provides a significant tailwind for smaller, rate-sensitive firms.

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As the likelihood of lower borrowing costs climbs, traders are giving small-cap names a closer look. At the same time, the relative price of bullish options tied to the Russell 2000 Index has dropped, making upside bets more appealing. That combination is giving investors fresh reasons to rotate into this long-overlooked segment of the market, according to several Wall Street strategists.

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Christopher Jacobson, co-head of derivatives strategy at Susquehanna International Group, noted in a client report that small-cap stocks have already started to respond to this shift in policy expectations. “After getting hit when markets braced for more hawkish rate-cut assumptions, the small caps have been a primary beneficiary of the recent dovish tilt,” he wrote.

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The performance data backs that up. The Russell 2000 has surged 8.5% over the five trading days through Friday an outsized move that accounts for more than 70% of its total gain so far this year. Options positioning also reflects growing enthusiasm. The volume of call options outstanding on the iShares Russell 2000 ETF, the benchmark’s largest tracking fund, has climbed to its highest level since September relative to put-option interest. That shift signals that traders are increasingly convinced the rally has room to continue.

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Small-cap companies tend to rely more heavily on short-term borrowing to fund operations and growth initiatives. Because of that, they are highly sensitive to movements in short-term interest rates.

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Recent messaging from Federal Reserve officials has reinforced expectations that a December rate cut remains on the table, while the possibility of a more dovish Fed chair taking over next year has added another bullish catalyst for the sector. Futures markets now place the probability of a December rate cut at 87%, a sharp jump from just 30% on November 19, according to CME Group data.

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Technical analysts are also becoming more constructive. Jonathan Krinsky, managing director and chief market technician at BTIG, wrote this week that he believes the recent breakout in small caps “is more likely to stick” given the improving backdrop and historical performance patterns.

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History, in fact, supports the bullish argument. The Russell 2000 climbed at least 1.5% in each of the three sessions leading into Tuesday. According to research compiled by Bespoke Investment Group, that pattern has occurred 19 times before.

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In those instances, the index tended to tread water over the next month but it delivered above-average returns over the following three months, six months, and full year. For traders looking for longer-term opportunities, that track record is difficult to ignore.

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Even with the recent surge, small caps remain behind the broader market this year. With one month left in 2025, the Russell 2000 is up 12%, trailing the S&P 500’s 16% advance. If that gap persists, the small-cap benchmark will finish its fifth straight year of underperformance relative to the S&P 500 tying the late 1990s for the longest losing streak in its history.

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That persistent lag has left valuations in small caps more attractive relative to large-cap peers, which some strategists argue could set the stage for a more durable rotation if rate cuts materialize and economic conditions stabilize.

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For investors willing to take on additional volatility in exchange for potential upside, the recent shift in options pricing and improving technical momentum may offer an early indication that sentiment toward small caps is finally turning.

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With the Fed’s December policy decision approaching and market expectations evolving quickly, traders are watching closely to see whether this renewed optimism will translate into sustained performance or whether small caps will again struggle to keep pace with the heavyweights driving the broader market’s gains. For now, the combination of dovish policy signals, improving historical odds, and rising investor positioning suggests that small-cap stocks may be entering a more favorable phase after a long stretch of trailing returns.

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