The Russell 2000® Index (RUT) hit an all-time record daily closing high of 1223.98 on February 24. Some investors still are bullish on the prospects for small-cap stocks and the U.S. economy, particularly in light of low energy prices.
Other investors have expressed concern about these points – (1) For the past year the price-to-earnings ratio for the Russell 2000 Index has been slightly higher than its 10-year average of 16.3 (source: Small Cap Perspectives by Russell Indexes (Dec. 2014)); (2) An online posting provided this headline – “History Favors Small-Cap Stocks Over Large-Cap in December-February” and quoted the head of technical analysis at Oppenheimer in regard to seasonality of returns for small-cap stocks, (3) Traditional fixed income instruments have low yields, and the dividend yield on the Russell 2000 is 1.35%, and (4) As shown in the chart above, indexes related to small-cap stocks, Treasury bonds and commodities all have experienced significant drawdown periods since 1986. In light of these points, some investors are asking –
- How can I efficiently lock in some of the gains I have made and protect myself from big drawdowns on my small-cap and fixed income portfolios?
- Can I enhance the yield for my small-cap portfolio in order to provide income and smoother returns?
In the rest of this Blog I will highlight three tools that can be helpful in exploring ways to manage small-cap exposure — (1) Options on the Russell 2000 Index (RUT) ; (2) CBOE Russell 2000 BuyWrite Index (BXR), and (3) Futures and options on the CBOE Russell 2000 Volatility Index (RVX).
1) OPTIONS ON THE RUSSELL 2000 INDEX (RUT)
- Large Contract Size. RUT options have a large notional size with $100 multiplier; approximately ten times larger than iShares Russell 2000 Index Fund (IWM) This may permit commissions cost savings based upon the number of contracts needed to attain the same notional exposure.
- Cash Settlement and European-style Exercise. With European-style exercise, there is no risk of early assignment such as for dividends; and cash settlement means there is no unwanted delivery or assignment of
Options on FTSE and Russell Indexes provide investors with tools to efficiently gain exposure to the U.S. and global equity markets, and to execute strategies for –
- risk management and hedging (e.g., with index options collars),
- asset allocation,
- income generation (e.g., with buywrites and cash-secured index puts), and
- expressing one’s view on the markets.
In formulating an options strategy, please keep in mind key factors such as the term structure and the volatility skew. The volatility skew chart below shows estimates for 30-day implied volatilities at various option moneyness on February 24; the estimated implied volatility for RUT options was 12.1 at 105% moneyness, and 34.1 at 80% moneyness. One could infer from the chart that there could be strong demand for downside protection with out-of-the-money put options on RUT.
2) CBOE RUSSELL 2000 BUYWRITE INDEX (BXR)
Another valuable tool for conservative investors is the CBOE Russell 2000 BuyWrite IndexSM (BXRSM), a benchmark index that measures the performance of a theoretical portfolio that sells Russell 2000 Index (RUT) call options, against a portfolio of the stocks included in the Russell 2000 Index. The average of the monthly gross premiums received by the BXR Index since June 2006 is 2.4% per month. Buywrite strategies can have drawdowns if the stocks held in the portfolio decline, and many buywrite strategies did have lower returns in 2013 when compared to U.S. stock indexes that rose more than 30%. Buy-writes can appeal to income-oriented investors in times of low interest rates and high p/e ratios. The BXR Index has had lower standard deviations than the RUT Index over the past decade. A January 2015 study Performance Analysis of Options-Based Equity Mutual Funds, CEFs, and ETFs provides a list of dozens of funds that are using the buywrite strategy. For more information on the BXR Index, please visit www.cboe.com/BXR.3) FUTURES AND OPTIONS ON THE CBOE RUSSELL 2000 VOLATILITY INDEX (RVX)
For investors who wish to add diversification instruments to a portfolio in times when there could be market stress and rising correlations of returns among various traditional asset classes, other instruments to explore include futures and options on the CBOE Russell 2000 Volatility IndexSM (RVXSM), a key measure of market expectations of near-term volatility conveyed by Russell 2000 stock index option prices. The RVX Index measures the market’s expectation of 30-day volatility implicit in the prices of near-term Russell 2000 options. CBOE disseminates the RVX index value continuously during trading hours. The RVX Index is a leading barometer of investor sentiment and market volatility relating to the Russell 2000 Index.
I want to highlight the fact that, in the years 2007 and 2008, the Russell 2000 Index (and many other traditional investments) fell, but the RVX Index rose more than 60% each year. Be careful to note that futures on volatility indexes often do not move as much as the spot volatility indexes; you can learn more about pricing and use of RVX futures and options at www.cboe.com/RVX.