What to Do with the Sideways Trend in Small-Caps

The following is a reprint of the market commentary from the February 2015 edition of The Option Advisor, published on January 22. For more information or to subscribe to The Option Advisor, click here.

In a recent commentary to my "Chart of the Week" subscribers, I discussed a stiff layer of resistance that's emerged for the small-cap focused iShares Russell 2000 Index ETF (IWM). The $120 region has kept a lid on IWM for the better part of the past year, most likely because it represents the convergence of two significant technical levels.

Specifically, $120.18 represents double IWM's October 2011 low, while $122.10 represents a 50% gain from the fund's December 2012 trough. Given the tendency of investors to "take the money and run" at these kinds of significant percentage returns, it's no surprise that IWM peaked just north of $120 on three separate occasions last year -- in March, July, and December -- before retreating.

In addition to these formidable price points, IWM is now staring up at an accumulation of more than 63,000 calls in open interest at the newly front-month February 120 strike. This is not necessarily a colossal level of outstanding contracts by "index-based ETF" standards -- but, given IWM's nearly year-long battle with $120, it's certainly notable that this is the site of peak front-month call open interest.

Anecdotally, there seems to be a growing consensus that small-caps -- on the heels of a disappointing 2014, relatively speaking -- are set to resume a leadership role this year. Consider this selection of headlines from the last month:

"How US small caps will pay for my son's tuition at Stanford" - MarketWatch, Dec. 30
"Focus on Small Caps in 2015" - Investing.com, Jan 6
"Stock pickers bet on small caps, Apple" - CNBC, Jan. 13
"Small caps to benefit most from US recovery" - The Globe and Mail, Jan. 16

So we have IWM trading beneath stubborn resistance, even as bulls appear to be ramping up their expectations for some kind of redemption narrative in the small-cap space, possibly including -- based on the front-month open interest configuration -- a breakout north of $120 in the short term. Do we have the makings of a bearish contrarian play on the small-cap ETF?

Well, not so fast. In recent months, IWM has established a floor in the $115 region. Since Oct. 31, in fact, IWM has settled outside of the $115-$120 range on only eight occasions. In other words, that's nearly three solid months' worth of a sideways chop within a roughly 5-point range. Not only is the potential reward for capturing a directional move within this channel rather strictly capped, but correctly timing such a trade would be extremely difficult.

In addition, IWM's rising 80-week moving average is now at $112.58, and has been increasing at a rate north of 50 cents per week. This trendline served as support over the course of the sharp pullback in October 2014, as there were just two weekly closes below this moving average, and the retest of 80-week support near the end of the month marked the "all clear" and the beginning of the subsequent IWM rally back to its highs.

One of the many advantages of options trading, of course, is the ability to capitalize on virtually any variety of price action, including the otherwise generally frustrating "sideways chop" now being demonstrated for us by IWM. If a trader wanted to profit from a stock's trading range, selling premium would be the way to go -- either by selling to open puts or calls individually, or by combining contracts to create iron condors or other flavors of credit spreads.

Of course, just because there's a strategy in the options universe that aligns with a given stock's price action doesn't necessarily mean you should jump to place the order with your broker. One of the "wild card" factors often overlooked (and at great cost) by novice options traders is implied volatility, which plays a significant role in determining an option's value -- and, by extension, your possible reward on a trade.

In the simplest terms, higher implied volatility is a detriment to premium buyers, but a positive for premium sellers. And when you're selling to open puts and calls, whether on their own or as part of a multi-legged credit spread, you are a net seller of option premium.

Our Senior Equity Analyst Joe Bell, CMT, has quite a bit of experience selling credit spreads, and IWM has been the target of more than one of his trades over the years. By his lights, though, the timing isn't quite right to sell premium on the small-caps. "Implied volatility has come down about 20% off its January highs," he notes. "While $120 continues to be a hurdle for the ETF technically, traders may want to watch for a spike in volatility to set up an entry for any premium selling positions." In the meantime, it would appear that the best IWM trade -- at least for the moment -- is no trade at all.