Small caps continue to close the gap on large cap stocks as the Russell 2000 (RUT) gained 0.52% last week while the Russell 1000 (RUI) was up by 0.18%.
On the volatility front the CBOE Russell 2000 Volatility Index (RVX) remains at the historical high end of value relative to VIX. This can be attributed to VIX hovering around multiyear lows as much as RVX not following VIX to the lowest end of the range.
On Monday, as the first trading day of the week came to a close one trader stepped up with a neutral to bullish RUT trade that we can explore from beginning to end. RUT was around 1352 when someone sold 140 RUT Feb 3rd 1330 Puts at 3.31 and then purchased 140 RUT Feb 3rd 1320 Puts for 2.04. The result is a net credit of 1.27 with a risk of 8.73 if the RUT had closed at 1320 or lower on the close this past Friday.
Note on the payoff diagram above that this trade turned out very well with RUT rallying into the end of the week and both put options expiring with no value. RUT was around 1352 when the trade went off and finished the week just shy of 1378. However, to quote Bud Fox’s boss as he was being arrested, “I knew you were a bad apple the minute I laid eyes on you.” That’s the feeling I had when looking at this trade. I decided to run some numbers, because they never lie, and that work confirmed by bad feeling.
I used RUT data from 2004 through this past Friday for the exercise I’m about to describe. The trade in question was executed late Monday so I used rolling 4 day performance data that gave me 3,290 rolling 4 day periods to compare to this trade. This trade had three potential outcomes, RUT at or above 1330 which results in a profit equal to the credit of 1.27, RUT between 1320 and 1330 which is a partial gain or loss, or RUT equal to or less than 1320 which results in a maximum loss of 8.73. To sync up history with current RUT prices I used percent changes to determine which of these three outcomes occurred historically. 1330 is 22 points lower than the 1330 strike price which is about 1.6% and 1320 is 32 points lower or 2.4% lower. The table below summarizes the results of looking at this trade and applying historical RUT market data.
Based on history about 77% of observations RUT was not down more than 1.6%, about 7% of observations would place RUT between 1320 and 1330, and finally 15% of the time we would have a maximum loss as RUT would drop more than 2.4%.
What is very startling is the last row where I summed up the profits or losses for each trade. Above 1330 and below 1320 were easy to calculate. However for the middle outcome I applied the price change to 1352, compared it to the 1330 strike price to see how far in the money the short put would be and then added back the premium of 1.27. Note that this trade repeated daily over history would result in losing over 2000 RUT points. That confirmed my impression of this being a Bud Fox trade.
I decided to take things one step further. Since I had the data I isolated all Monday close to Friday close price changes from 2004 through last week. This eliminates weekends, holiday weeks, etc. The net result was 563 observations and the numbers on the table below.
The breakdown of the three potential outcomes is very similar to that in the prior test. There were a few more range results than the non-filtered rolling 4 day performance analysis. In fact to get an apples to apples comparison I looked at the per-observation outcome and it was a loss of 0.61 for the full data test and an average loss of 0.60 for the filtered test.
I acknowledge this was a great individual trade and whoever executed it is a happy person this weekend. However, I like to look at history when analyzing trading decisions and with a neutral to positive outcome on the market I may have looked to a different trade with a little better odds based on history.