Why Small Caps Represent the Biggest Opportunity for Risk-Takers

The small-cap space still seems heavily shorted, despite RUT short covering

Senior Vice President of Research
Feb 16, 2021 at 8:56 AM
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While the SPX dipped into the red for 2021, it was a short-lived trip. Therefore, with the 50-day moving average sitting at 3,741, and the 2020 close at 3,756, this remains a first area of potential support if the market retreats... if you draw a trendline connecting higher highs since mid-November, the 3,920 level marks potential resistance into this Friday’s close, with last week’s high coming just shy of the 3,900-century mark.”

          - Monday Morning Outlook, Feb. 8, 2021

Last week was a familiar story, with the S&P 500 Index (SPX - 3,934.83) carving out yet another high thanks to a strong Monday session, in which the index charged above the 3,900-century mark. After that, it was pretty much sideways movement, with resistance coming into play at the 3,920 area, which I highlighted as the top of a channel dating back to mid-November. That was also when a positive vaccine update made headlines.

If you use the SPX’s channel to chart its course over the next week, resistance comes into play at 3,940 at the beginning, and 3,955 at the end. If the market retreats, the 3,810 level is a site of potential channel support at Tuesday’s close, while 3,825 is the site at Friday’s close.

If there is a move below channel support, the 3,750 level once again becomes a potential floor. This is also the 50-day moving average’s location, which contained the benchmark’s most recent pullback, when forced selling emerged amid a notable short-covering rally. The 2020 close is in the vicinity of this moving average, too. What’s more, the previous year’s close is at a level that has been important over the past few years. For instance, the 2019 close acted as support in late January of 2020, as well as multiple times over the second half of the year. Then, across the year-to-date breakeven point in February of 2020 began a period of vicious selling.

SPXMMOchart

It is expiration week, so I looked at the open interest configuration on the SPDR S&P 500 ETF Trust (SPY -  392.64) to see what levels would be important for both the SPY and the SPX. The SPY 395 strike, equivalent to the SPX 3,950, is home to almost 100,000 calls, most of which were bought-to-open. On one hand, a rally near this strike could spark delta-hedge buying that ends after the SPY gets through the strike. In fact, delta-hedge buying may have occurred in the last half-hour of trading on Friday.

But if the SPY remains below $395, a headwind could creep into play, as long futures positions related to the call open interest at that strike are liquidated as expiration nears. This scenario would be consistent with the SPX remaining in the channel discussed above. If stocks sell off, the 380 and 385 strikes -- which are equivalent to the SPX 3,800 and 3,850 -- would be potential options-related equilibrium points, given the hefty put and call open interest located at these strike prices. The SPX 3,850, for what it is worth, was around a closing high ahead of its late-January hiccup.

MMO 1216 2

I still prefer the small-cap space. Not only is there more short-covering potential in this space -- as I have been highlighting since mid-December -- but the technical backdrop looks firmer. For example, the Russell 2000 Index (RUT - 2,233.33) never dipped below its 30-day moving average, nor did it come remotely close to moving below its 2020 close of 1,975.”

          - Monday Morning Outlook, Feb. 8, 2021

Turning to the sentiment front, I have a few worthwhile observations. First, even though I have said I prefer small caps due to their short-covering potential relative to large cap stocks, I found the huge short covering in the second half of January on SPX components interesting (see the first graph below). Short interest on SPX components remains a little bit above the 10-year and 15-year lows that preceded market weakness. 

I have heard multiple guests and hosts on CNBC say that this is not a heavily shorted market, and I agree with those statements when considering only SPX components. However, despite short covering in the Russell 2000 Index (RUT - 2,289.36) over the past few reporting periods, I continue to see the small caps as heavily shorted, and thus the biggest area of opportunity if equities continue to advance.

MMO 1216 3

Continuing with the small cap versus large cap theme, I was amazed when our own Quantitative Senior Analyst Chris Prybal put the chart below, together last week. It is the 10-day, equity-only put/call volume ratio on only components of the iShares Russell 2000 ETF (IWM - 227.26). 

This IWM component-only put/call volume ratio is relatively high, in huge contrast to the all-equity, 10-day buy-to-open put/call volume ratio that I have discussed multiple times since early December. In fact, the IWM component ratio is at levels that have typically preceded market bottoms. Amid the concerns I have voiced and have heard others express about unusually heavy call buying relative to put buying in equities, small-cap stocks should not be included in this conversation. In conclusion, this graph further solidifies my view that if you are taking on equity risk, ensure you emphasize small-cap stocks.

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

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