Why Investors Should Be Picking Small-Cap Stocks

Other strategies, such as call options, are recommended as well

Senior Vice President of Research
Jan 19, 2021 at 8:23 AM
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Small caps may be the biggest area of opportunity, as measured by the iShares Russell 2000 ETF (IWM -- 190.30) and Russell 2000 Index (RUT -- 1,911,69).  With the IWM and SPY experiencing about the same performance in 2020, there is much more short-covering potential in the small-cap area relative to large-cap stocks.”

-Monday Morning Outlook, December 14, 2020

After year-end 2020 short interest data was released by the exchanges last week, I could not help but think about the comments that I made in the middle of December, as excerpted above. My sense, given the trajectory of moves we have seen in many individual stocks during the past few weeks, is that we have seen major short-covering rallies in the small-cap space since I made those mid-December comments.

Per the table below, this has translated into significant outperformance in small-cap equity-based exchange-traded funds (ETFs), relative to larger-cap ETFs such as the technology-focused Invesco QQQ Trust Series (QQQ – 311.86) or the broader large-cap SPDR S&P 500 ETF Trust (SPY – 375.70). 

1-18 chart 1

So how do you play this environment?  First, options can be used in lieu of stocks to reduce dollars at risk but allow leverage to work for you in the event you are playing stocks to the upside that might rally…”

          -Monday Morning Outlook, December 21, 2020

In fact, one of a few strategies that I have recommended during this past month is the use of call options as a substitute for stock plays in recognition of the bullish price action amid the sentiment-based risk, emerging Covid-19 vaccine headlines, and new strain uncertainties. Call options allow you to reduce your dollars invested, define your risk, and the leverage gives you attractive profit opportunities. 

With the above in mind, many of our subscribers benefitted directly from the small-cap, short-covering advance, taking huge profits on GameStop (GME), Bed Bath & Beyond (BBBY), SunPower (SPWR), Under Armour (UA), Shake Shack (SHAK) and Axon Enterprises (AAXN) call options. 

If the short covering continues, the best opportunities are likely to continue to be found in small-cap equities in the weeks ahead. 

While there has been short covering among S&P 500 Index (SPX – 3,768.25) components, which is likely supporting the index on pullbacks, total short interest is at a multi-year low. Plus, if you are looking at large-cap technology names, as measured by short interest in QQQ components, you may be fighting a headwind as short interest is building from a multi-year low.  

Meanwhile, short interest on Russell 2000 Index (RUT – 2,123.20) components is decreasing. From a broader perspective, total short interest on its components is nearer to multi-year highs, which leaves significant room for covering activity. Whether you are utilizing call options to speculate on individual stocks or allocating equity investments between small caps or large caps, ensure that you give the small-cap space focus.

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1-18 chart 3 regrab

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“…despite the headlines, some of which could have given the bulls pause, the SPX never breached the rising 20-day moving average, which sits below the first level of potential support on a pullback, which is the 2020 close of 3,756.07.”

          -Monday Morning Outlook, January 11, 2021

Ahead of the long weekend, Friday’s action saw everything pull back, whether large cap, technology, or small cap. Even though high-profile banks reported much stronger-than-expected earnings and President-elect Joe Biden released his stimulus plan on Thursday evening, buyers were nowhere to be found. 

That said, last week’s pullback in the SPX can hardly be defined as one that would stir panic among traders, who have been extremely bullish during the past several weeks. Friday’s SPX low, in fact, was around its 20-day moving average, which is now sitting around its 2020 close of 3,756, which I identified last week as the index’s first level of potential support.

1-18 chart 5 regrab

The CBOE Market Volatility Index (VIX – 24.34) rose slightly last week, but Wall Street’s “fear gauge” still isn’t hinting at major volatility ahead, as it remains well below its 252-day moving average. Moreover, per the first pane in the chart below, the round year-over-year 100% gain in this index acted as a “resistance” point, which has been the case since mid-December. 

Looking ahead to the end of the month, if this 100% year-over-year gain in the VIX comes into play, it will be on the heels of a surge into the 36 area in November, as it was around this time last year that it began rising from the 12 area into the 18 area, just weeks after China disclosed a novel virus had emerged in the country.

1-18 chart 6 regrab

One thing we are not seeing now relative to this time last year is the emergence of a significant number of VIX call buyers relative to put buyers, per the chart immediately below. These call buyers proved prescient with respect to their timing last year, when VIX calls were being purchased at a rate of four-to-one relative to puts in the previous 20 days. At present, this ratio stands at only 1.35.

1-18 chart 7

To conclude, one (or all) of the following strategies continue to be recommended:

  1. Use calls in lieu of stocks to manage sentiment-based risk but also play the current trend higher.
  2. Use straddles -- the simultaneous purchase of a call and put -- for the same reason as the first bullet (and to manage earnings risk).
  3. If not using call options as a stock replacement, consider index puts to hedge long stock positions.
  4. Emphasize small-cap stocks over large-cap equities.

Todd Salamone is Schaeffer's Senior V.P. of Research

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