Trading Nation

Small cap stocks serve up big warning

Small-cap warning to the market

For those trying to figure out where stocks will go next, one trader has a simple message: check out the small caps.

Since the Russell 2000 index is comprised of smaller, domestically focused stocks, some traders view it as a good tell on the true state of the U.S. economy. To stock market bears, this sort of underperformance in the Russell underscores broader weakness.

"The small caps have been consistently underperforming the broader stock averages and we're starting to see that weakness spread and pull broader averages down," Todd Gordon said Friday on CNBC's "Trading Nation." The index is down 5 percent year-to-date, while the S&P 500 is down less than 2 percent.

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Looking at a chart of the IWM, the ETF that tracks the Russell 2000, Gordon noted that the index was in a steady downtrend from July to October.

"The bounce from there has been pretty unimpressive, and we are expecting that downtrend to resume," added the founder. From its August low, the Russell 2000 is up 4 percent while the S&P 500 and Nasdaq are up a respective 8 and 15 percent.

To play for what he expects to be "further weakness," Gordon used an options strategy called a put spread. In this trade structure you buy a higher strike put and then sell a lower strike put of the same expiration to offset the cost.

In order to make the most money, traders want the stock to fall to the strike that you are short. Specifically, he bought the December 115/113 put spread for 66 cents. This trade is targeting the $113 level, which is nearly 2 percent lower than Friday's closing price.

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