The Russell 2000 (RUT) widened its lead on the Russell 1000 (RUI) after trouncing the large cap index the previous week. For the year, RUT is up about 15.8% while RUI is up one basis point under 7%. If you had been fortunate enough to pick the bottom in RUT you would be up just shy of 38% since February of this year.
Volatility spreads, as measured by the CBOE Russell 2000 Volatility Index (RVX) divided by VIX have widened out as they tend to do so in periods of low volatility. However, the 40% premium makes me wonder if some small cap players are looking to lock in 2016 gains after the recent run.
One of the first lessons I learned from Marty Kearney when he brought me into the Options Institute was when you think an option is expensive consider selling another expensive option to help lower the cost of a trade. That life lesson along with what I mentioned above about RVX being high leads me to this weeks highlighted trade. On Friday, with the Russell 2000 just under 1311 a trader came in and purchased 500 of the standard AM-Settled RUT Dec 16th 1250 puts at 8.10 and then sold the RUT Dec 16th 1200 Puts for 2.90 and a net cost of 5.20. The payout at December expiration below assumes this is a speculative short trade, but it could also be a position to hedge against a big drop in RUT over the next few weeks.
Note at least a 5% drop is needed for this position to start adding value. However, considering RUT is up about 12% in two weeks, this may not be out of the question.
Finally, an explanation on what I mean by expensive option. There are many ways to judge the value of an option, but one of the most common involves using implied volatility. Below is a skew chart I grabbed from the platform offered by out good friends at LiveVol. RVX was one method of depicting how high RUT volatility is, this chart shows the comparison between strikes. That red dot below is at a higher level than the green dot which means our trader was buying options with lower vol and selling ones with higher.