Options Market Signals Bullish Run for Small-Cap Stocks Amid Shift in Investor Sentiment

Options Newsman joined discussion · Jul 16, 2024 20:28

As market getting close to a key pivotal movement of monetary policy, a notable trend has emerged, revealing a growing appetite for small-cap stocks. This trend is underscored by the options market, where there has been a surge in demand for bullish call options tied to the $Russell 2000 Index (.RUT.US)$ —a signal that may point to a bullish trend for small-cap stocks.

The derivatives market is often looked to as a harbinger of market sentiment, and if recent activities are any indication, small caps may be on the cusp of an upward trend. According to Mandy Xu, head of derivatives-market intelligence at Cboe Global Markets, the volume of call options related to the Russell 2000 and an exchange-traded fund tracking the index has risen sharply. These contracts now trade at a premium relative to bearish puts, suggesting a robust confidence in the growth potential of small-cap stocks.

The volatility skew of the ETF tracking the Russell 2000 index, or Volatility Spread of 25-Delta Put IV minus 25-Delta Call IV, reached the most bullish level since last December. The implied volatility skew shows the market's bias for pricing in volatility risk to the option premium of downside puts and upside calls.

Options Market Signals Bullish Run for Small-Cap Stocks Amid Shift in Investor Sentiment

This pattern of heightened bullish sentiment is not entirely new. A similar trend was observed in late 2023 when investors positioned themselves to take advantage of potential Federal Reserve interest-rate cuts. The Russell 2000 outperformed its larger counterparts, the $S&P 500 Index (.SPX.US)$ and Nasdaq Composite, rallying more than 20% between November and early December.

The market's preference appears to be pivoting from the tech-heavy giants of the $Nasdaq Composite Index (.IXIC.US)$ to the smaller, more agile players of the Russell 2000. The small-cap index has recently seen outperformance reminiscent of moments following significant events such as the Lehman Brothers collapse in 2008, and the presidential elections in 2016 and 2020.

Federal Reserve Chairman Jerome Powell's recent dovish stance on interest rates adds fuel to the fire. Powell has indicated that the Fed is gaining confidence in the easing of inflation trends, and is also beginning to weigh the risks of a potential weakening in the labor market. This suggests that a shift toward cutting interest rates may not be far off, a move that traditionally benefits smaller companies more than their larger counterparts due to their higher sensitivity to borrowing costs.

Traders seem to have largely ruled out an immediate rate cut at the Fed's upcoming policy meeting, but the sentiment is shifting. Established financial analysts have interpreted Powell's latest comments to imply an impending rate cut, although no specific timeline has been disclosed. Goldman Sachs has taken an optimistic view on the matter, suggesting that there are "ample reasons" for the Fed to cut rates as early as July.

The convergence of a potential rate cut with a "Trump trade" has seen funds continue to rotate, with small-cap stocks leading gains for four consecutive days and the Dow Jones hitting new intraday and closing highs. Such a rotation underscores the broader market preference switch from large-cap to small-cap stocks, a pattern that, if sustained, could redefine the market landscape in the coming months.

Investors are now closely monitoring the options market and weighing the implications of these signals. If the bullish trend in small-cap stocks continues, it could herald a new era of growth and opportunity for investors seeking to capitalize on this shift in market dynamics.Source: Bloomberg, MarketWatch

Source: Bloomberg, MarketWatch

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