The secret small-cap warning sign
Small-cap stocks have had an incredible year. The Russell 2000, the small-cap index, is up 23 percent so far in 2013, easily besting the S&P, the Nasdaq and the Dow. But judging by options prices, that outperformance will not endure.
As the Russell moves higher, the Russell VIX—which measures the prices that investors are paying for options on the Russell 2000—should be expected to move lower. This is because investors generally buy options to get "insurance" on the index, so the Russell VIX tends to measure the amount of fear in the Russell.
The problem is that recently, "the Russell VIX is starting to move up as the Russell is making new highs. We like to see fear subside during those moments in time," said Brian Stutland, the managing member of Stutland Volatility Group and an "Options Action" contributor. But "The Russell VIX is now at a higher level than it was in March, yet the Russell itself is significantly higher."
So what does this tell us?
"Basically, hedgers are out there buying put protection," Stutland said. "They're protecting themselves in case this market rolls over for small caps."
For that reason, Stutland wants to buy some protection for himself—because such a surprising infusion of risk tends to indicate that there's trouble ahead.
The chart tells an identical story, according to Oppenheimer Chief Market Technician Carter Worth. The Russell 2000 "is trading in an unsustainably steep and complacent manner," Worth wrote in a Monday note. The index "is trading at levels where there is little or no upside and plenty of downside. ... Here's the summary: Sell."
On Friday, Stutland recommended trading his and Worth's thesis by making an options trade on the iShares Russell 2000 Index (IWM). Specifically, he suggested buying the September quarterly 97-strike put for $1.15.
Plenty of folks appeared to be on board with the trader's plan. On Monday, the 97-strike put was more highly traded than any other IWM put option for the September quarterly expiry.