Last week the performance for the Russell 1000 (RUI) and Russell 2000 (RUT) was as close as I’ve seen it since I’ve been doing these blogs. RUI gained 0.67% and RUT was higher by 0.65% for what we will say is within the margin of error (I’m stealing from the political polls). For the year RUT is maintaining a small lead on RUI up 6.78% versus 6.40%. This is the second week in a row with RUT in the lead which is pretty impressive considering back in February RUT trailed RUI by about 8%.
The small cap / large cap volatility difference widened out to levels not seen in all of 2016 this past week as the CBOE Russell 2000 Volatility Index held up more than VIX. The ratio on Tuesday topped 40% for the first time in 2016 and that ratio remained high for the balance of the week.
Finally, on Friday there was a pretty interesting trade that came to the RUT post. Late in the day with the Russell 2000 near 1210 there was a seller of 150 of the RUT Dec 16th 1300 Calls at 13.50, purchased the RUT Dec 16th 1190 Puts for 48.20 and then finished up the spread by selling the RUT Dec 16th 1140 Puts for 33.00. This results in a net cost of 1.70 per spread. I’m going to show the payoff at expiration for this trade and then I’m going to make an assumption about the motivation behind this trade and show another potential outcome at expiration.
The payoff diagram below shows the potential profit or loss for this trade based on different levels for the Russell 2000 at expiration. As a standalone trade this works best if we get a drop to 1140.00 or more between now and December expiration. In percent terms this comes to about a 5.8% drop.
Now I’m going to make an assumption. Let’s say this trade was done to hedge a small cap portfolio. The structure of this trade results in a low dollar cost to hedge a portfolio, allows for upside participation until the Russell 2000 hits 1300.00 and protects against a drop from 1190.00 to 1140.00. The picture below sums this up better.
I included being long the Russell 2000 from 1210.00 (red line above) just to show where the hedge helps and where it starts to become an issue for the portfolio manager. Portfolio managers are always trying to find a cheap way to hedge against a market drop. It appears one PM did just that with this three legged spread trade.