Small cap stocks get so close and then seem to fall back when reaching unchanged on the year or catching up with the performance of large cap stocks. This week the Russell 2000 (RUT) dropped 1.44% while the large cap focused Russell 1000 (RUI) lost 0.49%. This places RUT in the red by 1.86% for 2016 while RUI is still up 0.55%.


With the underperformance of small cap stocks last week came a relative rise in the CBOE Russell 2000 Volatility Index (RVX). The RVX / VIX premium began the week near 20% and finished the week closer to 30%.


Late Friday, in fact after the equity market was closed, but before RUT options closed at 3:15 pm Chicago time someone came in with a bearish outlook for small cap stocks, at least for next week. They sold the RUT May 13th 1050 Call for 67.00 and purchased the RUT May 13th 1125 Calls for 5.50 and a net trade credit of 61.50.


The maximum potential loss for this trade is 13.50 if RUT closes at 1125 or higher this coming Friday – this is also the capital that needs to be available to execute this trade (more on this in a second). A drop of 9% would be the best case scenario (although I have a hard time rooting for this) which would result in a profit of 61.50, or the credit equal to this trade. The break-even for this trade is down 4 points at 1111.50.

RUT needs to drop a little to hit break-even on this bear call spread, so that is an argument against what I’m going to discuss, but I want to share something I’ve been thinking about as of late. The margin  of putting this trade on is $1350 (plus commissions) and the trader can benefit from just about a one for one move to the downside in RUT up to a 9% drop. They also have limited their losses if RUT is up any more than 9.50 from Friday’s close.

Let’s assume this trader decided to use Russell 2000 Index Mini Futures. They would have sold short the June (TFM6) future. The margin, according to the ICE Futures website would be $5940, so that would be the capital commitment for this trade executed with futures. Additionally, the upside and downside for this trade have no real limits. This means the profits for an extreme downside move (more than 9%) could be greater than that for the option trade. However, this also means that a big small cap rally next week could result in losses that are theoretically unlimited.

My plan is to track this trade along with a short position in the Russell 2000 mini futures and report back on the results in this space next week.