The Best Way to Trade a Range-Bound RUT

Why an IWM put credit spread makes sense right now

Senior Vice President of Research
Nov 6, 2017 at 8:15 AM
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"With tax reform among the highest priorities in Washington, D.C. -- which you are sure to read and hear about in coming weeks -- this week brings us a continuation of earnings season and a full economic calendar...

"...[F]rom a macro perspective, the biggest news is likely to revolve around the Federal Reserve, with another policy meeting set for Wednesday and President Trump planning to name the next Fed chief by week's end. The latest speculation, as of Friday, had Trump favoring current Fed Governor Jerome Powell -- who many see as maintaining the status quo in terms of raising interest rates, and who is an advocate of deregulation in the banking industry."

    -- Monday Morning Outlook, October 30, 2017

Last week was chock-full of news -- both the anticipated, as excerpted above, and the unanticipated: the indictments of one-time Trump campaign manager Paul Manafort and his business partner Richard Gates in the ongoing investigation into potential collusion between the Trump campaign and the Russians during last year's election; a deadly terrorist attack in New York City; and then Friday's tweets from Donald Trump calling for the FBI and Department of Justice to investigate alleged collusion between Hillary Clinton and the Democratic National Committee (DNC) in the 2016 Democratic primaries.

Terror attacks (unfortunately), accusations of collusion, and policy reform have been a major focus of financial news media during the past several months. Such headlines tend to drive the market one way or the other day to day.  

Last week's Fed news was two-fold, with President Trump nominating Jerome Powell to chair the central bank after Janet Yellen's term expires in February.  Fed analysts think Powell will chart a similar course for interest rates as Yellen, implying a gradual path of rate hikes in the future. This should be good news for longer-term bulls, as the market has maintained its bullish course after four rate hikes of 25 basis points since December 2015.

Moreover, as expected, the Federal Open Market Committee (FOMC) did not raise rates this past Wednesday, which should tilt the risk-reward scenario in the bulls' favor over the next month. As I have been discussing for much of this year -- including last week's commentary -- the short-term action in the stock market is being driven by interest-rate decisions from the FOMC, which meets every six weeks. This observation is driven by the fact that the S&P 500 Index (SPX - 2,587.84) has generally experienced its worst four-week returns after the Fed raises rates, while experiencing its best returns when the Fed holds interest rates steady.

Since December 2015, the SPX was higher one month later in nine of the 11 instances when the Fed did not raise the fed funds rate. The average and median returns following such "non-actions" were 2.1% and 2.6%, respectively. The highest one-month SPX return was 5.1% after the February meeting, which compares to the weakest "no-hike" return, a decline of 1.4% following the late-July meeting.

spx after fed days since dec 2015

spx after fed raises vs spx after fed holds

"It was a tale of different tapes when observing the action in three equity benchmarks last week -- the Russell 2000 Index (RUT - 1,508.32), the Nasdaq Composite (IXIC - 6,701.26), and the SPX. Beginning with the RUT, the 1,500 century mark has continued to be a magnet since it was first touched on Oct. 2. In fact, by Friday's close, the 1,500 level had been crossed in nine of the past 10 trading days..."
    -- Monday Morning Outlook, October 30, 2017

Amid a potential Fed tailwind, small-cap investors are hoping that the Russell 2000 Index (RUT - 1,494.91) can make a decisive move above the round 1,500 level, which it has been unable to do for the past month.  In fact, as of Friday's close, it has now been 13 of 15 trading days in which the 1,500 level was either crossed or touched at some point in the trading day. While the Nasdaq Composite (IXIC - 6,764.44), Dow Jones Industrial Average (DJIA - 23,539.19) and SPX continue to grind out new highs, the RUT has been stuck in neutral for the past few weeks, continuing a theme this year in which small-caps have underperformed their larger-cap counterparts.

I suspect that 1,500 will continue to be a challenge for the RUT in the coming weeks. The good news is that since mid-October, pullbacks have been contained just below 1,500. In fact, the RUT has managed to close each trading day above 1,492 during this time -- its 10% year-to-date gain mark.

If you are an option seller expecting the next month on the RUT to play out like the past month -- that is, sideways movement in the 1,500 area -- you might consider an out-of-the-money put credit spread on the iShares Russell 2000 ETF (IWM - 148.61). Out-of-the-money put options are priced higher than call options, making put credit spreads more attractive if you are expecting continued sideways movement in the small caps.

rut hourly chart since oct 16

Finally, we're entering the two-week period before standard November options expiration, and this is a window in which the huge open interest that builds up on standard monthly options could influence market movements.  

In looking at SPDR S&P 500 ETF Trust (SPY - 258.45) strikes from 253 to 263, which is approximately 2,530 to 2,630 on the SPX, the big call open interest at the 259 through 262 strikes stands out. Our data from the exchanges suggests that a large majority of these calls were bought to open. If the SPY gets stuck in neutral in the coming days, and as expiration on Nov. 17 approaches, an options-related headwind will materialize, as long positions associated with the overhead calls will steadily be liquidated. If the SPY continues to grind higher in the days leading up to expiration, do not rule out a quick move to $262, or SPX 2,620, as the 262 strike is the last strike with significant open interest and delta-hedge buying will come into play.

If the SPY drifts lower, a potential support area from an options-related perspective is around strikes with equal call and put open interest, which is currently $255-$257, or SPX 2,550-2,570.  The $256 area aligns with the SPY's current 20-day moving average (see second chart below), which has contained all pullbacks since late August. SPY $257.49 and SPX 2,579 are levels to keep in mind as potentially supportive too, as this was the close on Wednesday, Nov. 1, when the FOMC decided to hold the fed funds rate steady.


spy november open interest 1103

spy 20 day moving average 1103

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