The options market is sending positive signals regarding the outlook for smaller companies, which is welcome news for small-cap investors. Options traders are now buying call options, contracts that give the holder the right to buy stock at a specific price until a certain date. They’re not just broad market options like the S&P 500; they are specifically buying the heck out of call options (calls) on small-cap stocks. This is a significant bullish sign, reflecting optimistic sentiment for the smaller companies.
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Can Small Caps Continue to Rally?
Demand for call options linked to the Russell 2000 and ETFs that track this small-cap index has risen significantly over the last few trading days. As a result, the contracts have rallied and become more expensive than bearish options.
This trend suggests that the current small-cap rally may continue in the short term. The situation is still young, but investors and options traders acted similarly in late 2023 when they believed the Federal Reserve would make aggressive interest-rate cuts. This would have affected small companies’ borrowing costs and debt structure.
Recent Small Cap Activity
As mentioned, between early November and early December 2023, the Russell 2000 surged. Over this short period, it rallied by more than 20%, outperforming both the S&P 500 (NYSEARCA:SPY) and the Nasdaq Composite (NASDAQ:QQQM). This extreme condition faded as hopes of interest rate cuts were vanquished. If expectations of rate cuts brighten, the situation could endure and grow stronger this time.
Last Thursday, trading volume for calls tied to both the Russell 2000 and the iShares Russell 2000 ETF (NYSEARCA:IWM) reached its highest level in years. Nearly 2.1 million calls related to the ETF were traded, the highest daily turnover since December 2009 and the sixth-highest on record since 2005. Call options directly linked to the index also saw their highest volume since 2021.
Sudden Small Cap Outperformance
The underlying stocks aren’t doing too shabby, either. Thursday was the Russell 2000’s best day since November. Small-cap stocks soared following a lower-than-expected June inflation report, which raised expectations that the Fed would cut interest rates in September.
Compared with the S&P 500, small caps saw their most significant outperformance since March 2020, when the COVID-19 pandemic caused a global market shock.
Over the last four sessions, the Russell 2000 has gained 7.7% and is on track for its best four-day run since 2020. The index just traded above its highest level since January 2022. In the meantime, the Dow and other market indexes have broken tens of record highs this year. The Russell 2000, over time, has a higher return (risk premium), so investors may think there is a lot of catching up to do.
Key Takeaways
Like the last time the market seemed sure the Fed would start lowering rates, small-cap stocks have begun to outperform. The options market gives small-cap stock investors a positive sign as the Fed creates more buzz around reducing rates. Demand for bullish call options tied to the Russell 2000 index has surged.
Call options allow traders to buy shares of the underlying stock or ETF at a predetermined price before the contract expires. As for the underlying stocks, the dramatic increase in interest suggests that the rally in small-cap stocks may continue into the future.
