Stock market gyrations this December have been attributed to the dominance of systematic trading driven by algorithms. While electronic trading may cause dramatic price swings in the market, there’s a meaningful behavioral element as well. Investors and traders are faced with sudden potential losses in their equity positions and a need to assess risk tolerances going into 2019.

The “January effect”?

The “January effect” hypothesizes a price increase in securities during the month of January. In theory, investors are motivated to reinvest after year-end tax loss harvesting, window dressing, or investing year-end bonuses. Historically U.S. small-caps have been more sensitive to the “January effect” than mid or large-cap counterparts.

Investors holding a Russell 2000 position already suffered a -13% monthly decline for December. With implied volatility on the Russell 2000 Index options above 30%, the fear of continued selling carries into early 2019. 

Consider the current uncertainty indicated by the options market. The RUT Jan25 ’19 1310 Straddle @ 93.40 using the mid-point prices on (12/27/18) forecasts a +/- 7% movement over the next month.  

Meanwhile, the “January effect” is questionable given that the Russell 2000 Index closed lower 6 out of the last 10 years as seen in the table below.

Russell 2000 Index 10 yr. January Index Performance

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Structuring an Asymmetric RUT Investment for Downside Protection & Upside Participation

Options based strategies using Index Options trading on Cboe: for example, RUT(W) index options offer the benefit to potentially manage downside price risk while maintaining long equity exposure. 

For those investors looking for downside price protection in the Russell 2000 Index, there are several option strategies to potentially consider. 

In this example, a hypothetical investor or money manager maintains a long Russell 2000 position and combines the following RUTW options position using the Jan. 25, 2019 expiration buying 1 x 2 RUT 1310/1225 Put Spread and selling 1 (one) 1410 Call.

This hypothetical position was established with the RUT Index level at 1,310. The net position yields a $2.00 credit or $200.00 and offers downside protection in the Russell 2000 to 1225 (6.5%) as well as upside participation which is capped at 1,412 (+7.8%) through expiration on Jan. 25, 2019. 

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At expiration, the position generates a potential profit if RUT closes between 1,412 and 1,225 as seen in the above table.  A settlement below 1,224 will expose the combined position to losses and an expiration below 1140 (down 13%) would expose the position to greater losses than without an options overlay.

Effectively, the options strategy protects against the first 6.5% in RUT downside until expiration. It allows for upside participation on the first 7.6%, but upside beyond that is capped until expiration. 

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Employing an options based strategy using RUT Weekly options as described can be an effective tool towards creating asymmetric returns whether for hedging downside risks or alternatively capturing upside price movement with limited downside price risks.

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