Going Small Ball with the RUT and Small Caps on Schaeffer's Market Mashup

What options plays to utilize with small cap stocks

Managing Editor
May 4, 2021 at 10:00 AM
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On the latest episode of the Schaeffer's Market Mashup podcast, Patrick is joined by Cboe’s Rick Rosenthal and Arin Risk Advisors’ Joe DeSipio to talk all things RUT and small-caps. They dive into small-cap's ascension and relation to economic expansion (6:00), its role in inflationary measures (10:05), and options strategies/products to employ in the small-cap market (19:38).


Transcript of Schaeffer's Market Mashup Podcast: May 4, 2021

Patrick: Welcome back to the Schaeffer's Market Mash up. This is your host, Patrick Martin. Thank you for tuning into last week's episode with Adam Warner; even though he's a Knicks fan, he had some great insight into the VIX. But today I'm very much looking forward to diving into the Russell 2000 index in the world of small caps. I've got two guests with me. The first is Aaron risk advisors, investment strategist, Joe DeSipio say hello to the crowd.

Joe DeSipio: Hello everyone. And thank you for having me, Patrick. 

Patrick: And then we have CBOE global markets, derivative sales, Rick Rosenthal, Rick, what is happening?

Rick Rosenthal: Hey Patrick. Thanks for having us. It's great to be here.

Patrick: Wonderful, wonderful. Hope everybody's doing well. Well, let's jump right in it's a small cap world right now for US market participants, as the rut continues to just, to leave large cap benchmarks in the dust. You know, even with, I think today's pullback, the rut is around 10% higher year to date. It has doubled off its March 2020 lows. So I guess the first question and I'll toss this one to Joe, is, will this breakout stick? It sounds like small ball, which as a basketball fan; I'm going to coin because I've never heard anywhere else. A small ball is going to be around for the time being right.

Joe DeSipio : Well, I'm about right, but it certainly appears that way because if you take a look at some of the activities as small cap stocks offer in comparison to say large cap stocks? The valuations that we see in small cap stocks are still a bit inexpensive relative to large cap stocks. And as people have this ongoing need to find value for their clients, even though people say value maybe dead as an investment strategy and growth is where it’s at. There's still a large number of investors out there who still want to invest for the long-term, they make sure they are paying decent prices for it. [Unclear 02:14], where you can do that right now is in the small cap world. Just because I don't think everyone's bound small cap as readily as they bound large cap, especially the findings over the last few years. And especially since the rebound recently everyone's kind of blocked into the small cap space, which is really, as you mentioned boosted different forums relative to the large cap names.

Patrick: So I'm looking at a chart here year over year of the rut, and you can trace some of the small cap rally really starting to pick up steam in November of 2020 when you had the COVID-19 vaccine rollout announcements. Does that mean that market participants are more optimistic about 2021 as a whole Joe, you can take that and then Rick, you can follow up.

Joe DeSipio : Sure. I always view investment or investing as a mosaic and one of the tile pieces would certainly be invest various vacations based upon an economic rebound. So in that regard, I think that's a net positive for small cap names, but you pointed out since the vaccine news and the stimulus news its become a lot more clear to folks. I think people have been a lot more willing to invest. And again, getting back to my fingers pointing  they've been trying to find places where they can invest that offer than, you know, good bang for the buck and that has been in the area of small caps.

Patrick: Okay.

Rick Rosenthal: [Unclear 03:43] some of Joe’s comments, but there's always uncertainty in the markets and it's hard to predict by even some of the best experts in the industry. But I might, I'm a half a glass, half full kind of guy and I am optimistic and I believe that market participants have reason to be more optimistic about the US economic recovery with the vaccine rollout. And we've got, let's give a mind the fed keeping rates low and a potential huge stimulus coming from the US government. What's interesting, you know, something you pointed out Patrick is that the Russell 2000 has been affected by the rollout of the vaccine. And I agree that the small caps could be the story here. They've led the rally and what they do is they measure the performance of small companies for the Russell 2000. These are companies that have a market cap between 150 million to 5 billion. And since last August, the Russell 2000 has been on a tear, it's rallied about 45% to new record levels. And this compares to the S and P 500 railing about 14%. So this is really a moment where the small caps have significantly outperformed their large cap counterparts. If you look at what happened in 2020, the storyline was besides volatility. Most of the performance has been narrowly focused and led by a handful of tech companies like apple, Amazon, Tesla, and Google. And we're seeing a rotation out of the tech stocks into the small caps. And as Joe pointed out, a lot of that is driven by value opportunities. Market participants are recognizing that there are value opportunities within the small cap segment, particularly when we're looking at an early stage of an economic recovery.

Patrick: And on that note, is that typical behavior for small caps to tend to outperform during economic downturns, and then almost act as an early or as a leading indicator during the early stage of an economic expansion, Joe you can take that one.

Joe DeSipio : You know, I just went back over kind of like the last [unclear 06:19] NBR recessions. That was like in the early eighties, the early nineties, the early [unclear 06:24] the 2000 [unclear 06:27], thousands of the credit prices, and then the most recent pandemic prices where we've gotten into this recession category. in each of those markets as we come out of that small caps have significantly outperform large gaps. And just by the kind of the back of the envelope numbers I came up with its somewhere around 20%. So that's a huge differential as you're coming, as the economy is getting itself out of recession. So there seemed to be, you know, a very high data, if you will, to economic rebound for small companies versus large companies. And this last go around has not been, you know, disappointing. We're still, you know, I think the performance [unclear 07:07], you know, 25%, if we start from like October 31st down to March 4th of seven.

Patrick: So you mentioned this time around, is there any context that a retail trader can look at this current rally and say like, okay, this has happened at other points in history where small caps have outperformed Rick, you can take that and then Joe can follow up. 

Rick Rosenthal: So I want to point out that when we're looking at the Russell 2000, this is an index that measures the performance of small cap companies that are domiciled in the U S and these companies generate the majority of their income domestically. Typically these small cap companies are leveraged they're nimble, and they tend to outperform larger companies during periods of economic expansion. And so what we've seen in the past you know, over the past four decades the large cap stocks have typically outperformed small caps in large measure due to the sector weightings and the indexes. Now, the tech sector has been the main driver of economic expansion. And if you look at the sector waiting for information technology and the S and P 500, it's over 27% versus 14% in the Russell 2000. So what makes this particular cycle different I believe it's a combination of the low interest rates. Fed's intention to maintain a low interest rate posture. The stimulation package that's being proposed by the US government, 1.9 trillion, and the impact that these combined stimulus and the vaccine rollout is creating an expectation that there's going to be a significant impact on the smaller companies. And we can see that from the current rally 

Joe DeSipio: And chime in for a second. We also see that in Alice expectations in the small cap space, too. So analysts are getting on board with the fact that as Rick pointed out, these small cap companies have a pretty good shot of growing their earnings as the economy rebounds.

Patrick: Okay. So when you said analyst expectations, does this mean they were perhaps on the sidelines in earlier months, and they're just now coming around?

Joe DeSipio:  Maybe a little bit, I wouldn't say on the sidelines, I would say let's use the word less gleeful, less certain, less positive, but, you know, expectations are coming in pretty strong for the small cap space.

Patrick:  Interesting. You, we started to kind of dance around that, but I want to jump into the inflation expectations since that's pretty pertinent right now, it's not a new phenomenon that the performance of small cap versus large cap tracks inflation expectations 2020 is a perfect example of that. Joe, do you want to unpack that a little bit and then Rick can go.

Joe DeSipio: Yeah. I just think for some of these smaller gap names that, you know, as Rick pointed out, they tend to be highly leveraged. And if you're going to be highly leveraged in inflation you know, potentially could be a benefit to you if you're a borrower, right? Because I saw the payback a hundred cents on a dollar, I just get to pay back with cheaper and cheaper money. So that may be one reason why the small cap needs, small cap space has benefited a bit from this presumption that inflation is going to pick up. Now, of course, the chairman Jerome Powell of the federal reserve would argue that any type of inflationary expectation that people have is going to be short-lived and don't get too excited about it as the bed is not. So I would just be a little bit cautious in that regard. 

Rick Rosenthal: Okay. So to jump in today, non-farm payroll came out, it rose by 379,000. Most of that were jobs created by smaller companies. If you look at what's happened to the 10 year treasury, it's up by almost a half a percent year to date. And that's despite the fact that the fed has announced their plans to keep rates low. So combination of, you know, rates going higher, jobless, non-farm payroll going up there's a lot of anticipation that we're going to see a rapid economic recovery. And during that, during an active and a rapid economic recovery, small caps tend to outperform, and we're expecting to see that. And we're seeing that with the outperformance of the Russell 2000 year to date inflationary pressures will impact sectors differently. And the large weightings for the Russell 2000 happened to be in healthcare, consumer discretionary, industrials, and financials, and these four sectors are sensitive to interest rates. So the low rate environment has been helpful for healthcare and consumer discretionary, ironically, when you have a rising interest rate that's very beneficial to the financial sector. So it's almost like the perfect storm for the Russell 2000 right now.

Patrick: And I'm going to tell on myself here and say in our dry run, I think Rick mentioned intentional inflation, how it's very important that that's, when there's intentional inflation that almost sets up the perfect storm instead of being a random event, is that correct?

Rick Rosenthal: We had a manufacturer recession and we're also experiencing a manufactured recovery. So when you've got the fed reserve maintaining low interest rates and pumping money into the system, you have the US federal government creating a $1.9 trillion stimulus package. The intention is to revitalize the US economy and small caps on the front line. They were the first to experience the downturn, and they're going to be the first to benefit from this recovery.

Patrick: Okay, well said very well said, Rick, talk to us about the dramatic volume going way up. We've seen lately with the Russell 2000 listed derivative ecosystem and how is this translated into CBOs launch of mini Russell, 2000 index options and misses rally because I know you've guys got, you know, a big thing that just popped up for you.

Rick Rosenthal: Well, thanks. I'm going to potentially embarrass myself by pointing out that I've been in this industry for 40 years and was on the floor of the Chicago mercantile exchange. When the Russell 2000 index futures were launched in 1993 a lot has changed since then, and the ecosystem for the list of derivatives on the Russell 2000 complex has grown. And I'm happy to say the E-mini Russell 2000 futures moved back to the original home of the CME on July 10th, 2017. And since then, the volume in the future says grown significantly, a year ago, CME launched a micro mini Russell 2000 futures contract in response to the growing demand from retail participants. And I'm happy to report this past Monday, CBO listed a mini version of its Russell, 2000 index cap settled index option. And this mini index, ticker is M R U T is very similar to the standard contract, but it's one 10th, the notional value. So instead of trading a contract, that's got a notional value of 220,000. This mini product has a notional value of 22,000. And some of the features that it offers are significant benefit or advantage over the option on the ETF it's cash settled, it's European style, no early assignment, it's got the 1256 tax benefit, meaning it's a 60, 40 blended rate long-term short-term. So we've got a lot of interesting products to express a view on the Russell 2000. And if you were to combine the average daily volume and all the listed derivatives based on the Russell 2000, including futures and options. The notional value of this daily volume is 47 billion, and we've seen a significant growth year over year as it's grown by over 66% in terms of average daily volume year over year. So this is a great time for market participants, interested in the small cap segment to use listed derivatives like Russell 2000 futures, mini futures, Russell 2000, options, mini index options for managing risk, expressing a market view. You know, trading volatility, you have deep liquidity and price transparency that's offered by these exchange listed derivatives.

Patrick: You know, that's, I mean, how is that for timing March 1st, you guys roll this out when all eyes are on the rut right now, I think that's perfect for you guys and congratulations. And then you mentioned trading volatility. So that means that market participants, they don't have to choose between being bullish or bearish, correct?

Rick Rosenthal: That's right. Yeah, and volatility is an interesting aspect of trading options and it's one of the few tools that's available to investors for isolating volatility. So what goes into the pricing of a, of an option includes, you know, the length of time till expiration, the intrinsic value, supply demand factors and volatility. So Russell 2000 volatility is an interesting component in and of itself because the underlying small caps aren't leveraged, they're smaller in terms of market cap. There's more volatility associated with small caps. So CBO calculates the volatility index. Most people are familiar with VIX, which is the volatility on the S and P 500 expressing a 30 day view of future more market expectation of volatility. We have the Russell 2000 volatility index, RVX is the ticker. And right now that is 36 compared to VIX at 27, it's got a 10 point premium over VIX. And typically it's about four, now it's 10, which tells you that there is an anticipation of continued volatility in the market, even though the Russell was reaching record levels, it maintained a high level of volatility. And so this is a great opportunity for those participants that want to look at the opportunity to harvest income, harvest premium, kind of like an insurance policy where insure is selling its insurance to the buyer. And the buyer's paying a premium to an insurance company, you think of options along those lines. An option seller is going to collect that premium. And you can see by the volatility on the Russell 2000, there's more premium, more volatility embedded in that product.

Patrick: Yeah. That's fascinating that you said that there still could be more to come, you know, even amidst all of this volatility that we've seen in the past three months. It's, there's still, there's plenty of runway left. And as you, as I noted, there's tons of eyeballs on this. So very exciting stuff that you guys have going on. Joe and this will be to wrap up here. Rick talked about a bit, a little but for market participants, are there examples of specific options strategies that someone can keep in mind with a specific view towards the small cap market?

Joe DeSipio: Sure. I think with the introduction of [unclear 19:55] and the options on [unclear 19:57], investors can, you know, test these trades out just to make sure they are appropriate and suitable for them. But some of the trades that people may be interested will be you know, selling puts and that takes on Rick's insurance company example where you receive an upfront premium and that's going to be a maximum gain. So if the Russell continues with its move or a surge higher, you're only going to participate with that limited amount of premium you collected and you are going to be facing the downside risk of being a short back put. So I just wanted to be sure that any of these options strategies are mapped out in advance, say your expectations for return are going to match what your realization is of return over time. Other things that people have looked at in terms of just trying to create some additional or differentiating cash flow for investors have been even covered calls and a covered call strategy is your, you take your small cap exposure, and then you sell a call option against those holdings and you can use [unclear 21:11] or rut for that purpose. And that's another way to generate incremental income. Again, when you're selling those options, selling those call options; you may be faced with capping your upside. So just again, it's a matter of expectation relative to which strategy you employ.

Patrick: Well said, well said. Rick you got anything to wrap up with?

Rick Rosenthal: Well, I have to say what Joe said is absolutely music to my ears. He's an industry practitioner and an expert, and he's been doing this for many years. And the reality is you buy a stock, you can go up or down or stay the same, same thing with futures. What makes options different is that you can design a strategy and shape an outcome that you're looking for. So as Joe pointed out, if you own the underlying, the Russell 2000 and you want to sell a call, essentially, you're interested in maintaining a long position. But you're collecting income; it's an alternative way to generate income. CBOs created a number of these strategy benchmark indexes on a Buy-Rite cast secured port rights, zero costs put collar. They have one that's getting a lot of interest and that's the Russell 2000 buffer protect index. And this is based on an options position that's constructed for a particular outcome. And that's for investors who want to maintain a long position in the Russell 2000 have downside protection in this case, 9% downside buffer protection and upside participation. The upside participation is going to be capped because you're selling a call to finance the cost of the put. So depending on how much premium is collected on the sale of the call, determines what the upside participation is, but it has the very similar outcome as a structured product, which is used by many advisors today. And this is a great alternative to a structured product because you can have, you know, price transparency, it may be less expensive, and you've got the options unclear 23:32] Corp as a counterparty. And it's a, you know, very stable financial counterparty. So options are a great tool for market participants that want to express the market view. They want to shape the outcome, or they want to trade volatility.

Patrick: Very well said, and music to my ears, everybody, I promise I didn't make them say those things because that's basically an audio version of the education articles that we put out two or three times a week. So there you go. If you want an audio book, just listen to our podcast. So I couldn't thank you enough for that endorsement of options at the end, Rick, Joe, do you guys have any, I know Rick talked about, you know, the big announcement, Joe, do you have anything you guys want to close with?

Joe DeSipio: No, I just made one final point that Rick kind of touched upon is when you're using listed options, as opposed to a structured product, you get to change your mind. And I think that's a very important thing in today's day and age, when you, when news is changing and you want to be able to change your view, listed options, allow you to do that. 

Rick Rosenthal: One thing I'd like to add to that is education is key. And I assume that your listeners are very interested in options and learning more. CBO is also a great resource for you. I would suggest you go to cboe.com forward slash RUT for information on the Russell 2000, CBO [unclear 25:10] dot forward slash M R U T for the Russell mini product, and then check out our options Institute. They've got all sorts of webinars and some research available for those interested.

Patrick: Outstanding. I love, ending with plugs. You know, we always got to plug your stuff. We've got Aaron risk advisors, investment strategist, Joe DeSipio and CBOE global markets, derivative sales, Rick Rosenthal, gentlemen, thank you so much for coming on. You know, it's, it'll be exciting to watch, you know, what the rut does in the next six months to a year and, you know, thanks for educating me as well. 

Rick Rosenthal: Thanks for having us, Patrick, cheers guys.

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