The Continuing Case for Tech Over Small-Caps

IWM may have hit a short-term bottom, but QQQ still holds more appeal for bulls

Aug 29, 2017 at 9:58 AM
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The following is a reprint of the market commentary from the September 2017 edition of The Option Advisor, published on August 25. For more information, or to subscribe to The Option Advisor -- featuring 10 new option trades each month --  visit our online store.

As most dedicated market-watchers have likely already observed, small-cap stocks -- as measured by the Russell 2000 Index (RUT) and its exchange-traded fund counterpart, the iShares Russell 2000 ETF (IWM) have underperformed the S&P 500 Index (SPX) by a significant margin in 2017. Meanwhile, the tech sector -- represented by the Nasdaq-100 Index (NDX) and its companion PowerShares QQQ Trust (QQQ) -- has outperformed to a degree that's equally remarkable. That said, the activity in IWM options has provided useful clues for those looking to pinpoint tradable bottoms in the small-cap ETF this year, with the latest of these signals flashing as recently as Friday, Aug. 18, when monthly options expired.

Specifically, a buy signal for IWM has been generated from a simplistic heuristic that has worked fine in 2017, based on its few occurrences: "Climactic IWM put volume day + IWM trading down at or near its 2016 closing price = IWM bottom, followed by a sharp rally to the top of its trading range". Note below the key intraday lows (relative to the 2016 year-end close of $134.85) and corresponding daily put volume climaxes (relative to the 2017 year-to-date peak of 874,939 set on April 28) for IWM:

  • 3/21 = $133.92 low + 708,914 puts
  • 3/22 = $132.78 low + 829,714 puts
  • 5/17 = $134.75 low + 719,760 puts
  • 8/10 = $136.26 low + 704,002 puts
  • 8/18 = $134.12 low + 704,976 puts

iwm put volume climaxes since december

But a starkly different picture emerges from the declining trend in IWM put open interest which, along with IWM's flat price action this year, can actually be said to have bearish implications for IWM (at least, relative to the other major indexes). From its mid-December peak around 6.2 million contracts, put open interest on IWM has declined to its current level of 4.5 million contracts -- a fairly anemic reading that registers in only the 46th percentile of its annual range, per Trade-Alert. So during an approximately eight-month stretch that resulted in almost zero net movement in IWM, put open interest on the small-cap tracker decreased by roughly one-quarter.

The contrast with QQQ's put open interest trend over this same time frame is startling. Put open interest on QQQ has nearly doubled from mid-December to stand at 4.9 million, which Trade-Alert places in the 88th percentile of its annual range. This ramp in put open interest has occurred simultaneously with an approximate 19% rally in QQQ.

qqq iwm put open interest since december

Equally notable is the migration in 30-day at-the-money implied volatility (ATM IV) over this period. While IWM 30-day ATM IV barely budged, rising from its Dec. 16 perch at 15.8% to the Aug. 18 "buy signal" day level of 15.9%, QQQ 30-day ATM IV popped from 12.6% to 16.4%. (For perspective, 20-day historical volatility in both instruments registered net changes of less than one percentage point over this eight-month stretch.)

So, basically, QQQ hits the ball out of the park this year on price performance, and this is accompanied by a massive increase in QQQ put open interest and a significant pop in QQQ IV (which strikes me as quite a bullish contrarian case). Meanwhile, IWM has traded barely above breakeven for most of 2017, amidst an environment of declining put open interest and flat IV. Based on this options data and that on the charts, I see every reason to believe QQQ's outperformance relative to IWM will continue to play out according to the year-to-date pattern already in place.

And there's not necessarily any contradiction between the bullish implications for IWM reflected by the "daily put volume climax signal" versus the bearish implications of the put open interest trend. IWM may well have just put in another of its bottoms near its 2016 closing price -- but the ensuing rally will, once again, likely be vastly inferior to that put on by QQQ. So, perhaps the right action step -- if the implications of both charts are to be believed -- would be to buy QQQ. Because if this year's underdog is about to pop, then this year's star should continue to outperform.

As a final note, it's worth pointing out that rising put open interest levels on the major equity-based ETFs -- QQQ and IWM included -- is often indicative of share accumulation by hedged players. If large stock market players are buying tech shares and passing up small-caps, that reinforces the broader takeaways above, but with the caveat that these investors will likely reach a "point of maximum investment" -- and at this apex, the sector becomes vulnerable (although, thanks to the put option hedges in place, the prospect of panic selling is significantly tempered). Right now, we have not yet reached this point with QQQ; following a drop-off in put open interest coincident with last Friday's expiration, put open interest has accelerated steadily so far this week -- and still has room to climb before revisiting its 2017 high north of 6 million.


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