The market is reeling after the Fed hiked rates and gave a less than cheery outlook for 2019. The FOMC ruled yesterday that it plans two interest rate hikes next year, compared to four this year. Part of this reason is the committee’s lackluster forecast.
Fed Chairman Jerome Powell told reporters this following the two-day meeting (emphasis ours):
“Despite this robust economic backdrop and our expectation for healthy growth, we have seen developments that may signal some softening relative to what we were expecting a few months ago. Growth in other economies around the world has moderated somewhat over the course of 2018, albeit to still-solid levels. At the same time, financial market volatility has increased over the past couple of months, and overall financial conditions have tightened–that is, they have become less supportive of growth.
Now, you can see he tried to temper this less than favorable outlook. But the message was still read clearly by Wall Street. After all, how can the outlook not have “fundamentally altered” when FOMC members have lowered their growth forecasts?
The Dow, which had been poised to move throughout the two-day meeting, fell yesterday afternoon and even further today.
This brings the index’s year-to-date losses to 8.5%. From its early October peak, it has shed 15.3%.
An interest rate hike accompanied by a weak forecast is certainly the driving factor right now. And with the President flip-flopping on whether he’ll even sign the budget extension, the pressure from incoming Democrats in two weeks’ time and the continuing uncertainty over trade issues, this weakness should be here to stay.
As you can see the major stocks in the market have already been hit. But the real losers here if this kind of weakness continues will be the smallest of companies.
While higher interest rates mean consumers have less money to spend, causing large companies downward pressure on their sales, they still are able to lock in low rates themselves and generally still have cash flows and balance sheets to absorb higher rates.
Small companies, on the other hand, rely much more heavily on debt to finance growth. Meaning higher rates and lower consumption is a terrible situation for them.
It’s clear investors have already picked up on this fact. Take a look at the Russell 2000, which covers 2000 of the smallest stocks in the market:
That fall from its late August peak represents a 24.2% decline. That’s true bear market territory for small caps. And this latest news and outlook appears like this is one trend that’ll be around for a while.
So, how do you hedge any losses you might have in small caps? Better yet, how could you actually profit from this extended weakness?
A Strategy For Small Cap Weakness
More and more you’re seeing financial advisors discuss the benefits from investing in index-linked funds. The reason for this is simple, indexes do generally outperform managed funds over long periods of time. Trading these indexes, however, is usually a bit harder.
For instance, the Dow Jones Industrial Average represents just 30 stocks. Any one of them could crash or explode on the upside and completely change the direction of the index’s movement.
But sometimes, this kind of trade just makes sense. This is one of those times.
Now, you could try to short a small cap ETF or a handful of small caps individually. But as we’ve noted before, that’s a messy strategy with too many risks.
You could instead simply buy a put option on, say, the iShares Russell 2000 ETF (IWM), where each $1 of this ETF’s price equals about 10 points of the Russell 2000. Again, that’s more like a casino bet than investing. The index would definitely have to tank to see a profit.
There’s a third strategy to play a situation like the one we find ourselves in today. And instead of spending money to enter a trade, you could collect income at the start of it.
A bear call spread is strategy where the trader sells a call options on a stock or ETF he thinks will go down and then buys a second call option with a higher strike price. That results in a net credit to the trader’s account.
What this does is lets the trader collect that income, his maximum profit, right at the beginning of the trade. Depending on which strike prices he chooses, the underlying security might not even have to move to keep the full amount.
You can see how a bear call works in this chart:
Source: The Options Industry Council
We know, it seems strange to make your total return at the beginning of the trade, but it’ll make sense in a minute. Let’s look at a specific trade using this strategy.
A Specific Trade on IWM’s Weak Outlook
A trader looking to enter a bear call spread on IWM (small cap ETF discussed above) could sell a January 18 $132 call for $4.21 per share and buy a January $134 call for $3.27 per share. Since each option is worth 100 shares, that works out to a net credit of $94 ($4.21 – $3.27 = $0.94; $0.94 x 100 shares = $94) hitting his account immediately.
That’s the maximum the trader would make on this trade. The fortunate thing about this, however, is that the Russell doesn’t even have to go down at all to keep that full $94. But it can’t go up much.
You see, the risk of this trade is if shares rise above the strike price of the sold call. That would put that option in the money and be at risk of being exercised away from the trader. That risk too though is capped at the second call option in this trade. If shares rise above $134, the trader wouldn’t lose any additional money.
To find the total amount at risk for this bear call spread, take the difference between the strike prices and subtract out the premium received at the beginning of the trade. That works out to a maximum risk of $106. Here’s the math:
$134 – $132 = $2;
$2 – $0.94 = $1.06;
$1.06 x 100 shares = $106
So, this trade’s maximum profit (the amount received right at the beginning) represents a return of 88.7% of the amount of money at risk. That’s the return a trader would cash in if small caps remain weak, no matter if they fall or stay the same price.
With a not-so-pretty outlook, that’s a nice return for little risk.
— The Option Specialist