- The stock market broadened as investors shifted from the tech-heavy Nasdaq to small-caps.
- The Russell 2000 index surged 10% since July 9, while the Nasdaq dropped 8% after July 10.
- Options traders are selling puts on the IWM to capitalize on the small-cap trend.
The stock market is finally broadening after mega-cap technology names carried most of the gains for the highly concentrated S&P 500 over the past two years.
Where are investors going, you ask? It's probably toward small caps. The big market shift is now a sector rotation away from tech-heavy Nasdaq names and into the Russell 2000. The small-cap index entered a multi-day rip on July 9, up by about 10% since then. And it's coincided with a downturn on the Nasdaq, which reversed on July 10 and is now down by about 8%.
If you're a trader who wants to bet that the trend will continue, there are many ways to play this. You could simply buy shares of an ETF that tracks the Russell 2000, like the iShares Russell 2000 ETF (IWM), or short one that tracks the Nasdaq, like the Invesco QQQ Trust (QQQ). You could also take a bullish and bearish position in options.
If you want to pursue options, it can become very complicated or remain somewhat simple, though not as straightforward as buying shares. However, going the extra mile could help traders capture asymmetrical returns with upsides that exceed downside risk.
Liz Dierking, a co-host of a derivatives show on Tastylive and a veteran trader, says her choice of trade in this scenario would be taking on a neutral to bullish options position on an ETF that tracks the small-cap index that would allow her to collect a premium even if the ETF slightly dropped in price. One way to do this is by selling an out-of-the-money (OTM) naked put on IWM.
This contract binds the seller to an agreement to potentially buy the underlying shares of IWM at the strike price, which is the agreed-upon price the underlying shares would be purchased for if exercised. The put is OTM because the strike price is below the spot price. In this instance, the contract buyer would exercise the option if the market value of their shares dropped below the strike. In exchange for her promise to buy them, Dierking collects a premium on the contract upfront.
If you have a bullish outlook on the IWM, you expect the share price to continue rising or at least not drop below the strike price. This would allow the contract to expire worthless, and the seller would keep the premium collected without buying any shares.
Picking the appropriate strike price is subjective and based on a trader's risk tolerance and the premium they're looking for. Dierking noted that the strike should be one you'd be willing to pay if the contract is exercised.
As for the contract's duration, the optimal days to expiry on a contract is between 45 and 60 days, according to Tastylive's research team.
"As a premium seller, meaning that we're selling something that is technically intrinsically worthless, we want it to just decay," Dierking said. "So we want to pick something where the decay curve is the highest, and that's between 45 and 60 days; that option will decay at the quickest."
For example, at noon on July 24, Dierking sold a naked put at a strike price of $215 with 58 days to expiry when IWM was trading at around $221. If IWM remains above $215 over the next 58 days, her contract expires worthless and Dierking keeps the premium which is $444. If the index happens to drop below that strike, the buyer would exercise the contract and Dierking would be forced to purchase the shares. The risk here is that you have to be willing to buy 100 shares of IWM if the trade goes against you.
"So if it comes down a little bit, but not all the way to 215, no one is going to exercise their right because it wouldn't be beneficial to them," Dierking said. "That's just going to expire worthless and I get to keep that cash."
The options chain below demonstrates that the 215 strike has the highest open interest at 27,000, steeply above other contracts.
Since options contracts are purchased in lots of 100, it could seem nerve-racking to think you may need to accept delivery of those shares. But if you were already willing to buy IWM at its higher spot price, you could sell a naked put for those shares at a lower strike and get paid the premium. Worst-case scenario, you end up owning IWM shares at a cost below what you would have bought them for on the spot market, Dierking said. Once you take possession of those shares, your maximum loss would be the same as a shareholder of IWM.
