The market is coming off a two-week period in which it has had to digest an awful lot of economic data: durable goods, 1Q GDP, new home sales, factory orders, ISM and, of course, non-farm payrolls. Not to mention, amidst all this data, the market also had an FOMC meeting to digest. I have always found it useful during the onslaught of data to refer to the Citi Economic Surprise Index. After all, it isn’t so much the absolute measure of the data. It comes down to whether the data is better or worse than expectations. The Citi index measures exactly that and is a mean-reverting index as a result. Looking at the index in white in the chart above, we can see that since early April, the data has come in considerably worse than expected.

Until very recently, however, the short-term interest market hadn’t flinched. Even going into the FOMC meeting on May 1, there was still some concern that the FOMC may hike rates this year, as evidenced by a question posed to Fed Chair Jerome Powell at the press conference. Chair Powell put that notion to rest, and with a weak data point in the non-farm payroll data days after, is beginning to focus on the weakness of data and what this means for short-term rates.

The 2-year yield is an accumulation for what the bond market thinks of Fed actions over the next two years. You can see that when I plot the futures contract inverted (giving me the yield), the time series of each plots very well versus the other until very recently. The implication here may be that the economic data is telling the market that short-term rates need to come lower in the near future because high rates could be impacting the economy. 

Equity markets and short-term rates markets are tied at the hip because the risk-free interest rate is the beginning of the process for determining a company’s cost of capital. If I aggregate this up to a market measure, there is a link between risk-free rates and the Price to Earnings multiple an investor should be willing to pay for the market. The higher the cost of capital, the lower the P/E one should be willing to pay. The lower the cost of capital, however, the higher the P/E one would be willing to put on the market.

In this chart, I have plotted the 2-Year Note futures vs. the forward P/E for the E-mini Russell 2000 small-cap futures. As 2-Year Notes go higher, the risk-free yield is falling. As the risk-free yield falls, investors should be willing to pay a higher P/E. If we look at this over the last couple of years, we can see that the intuition matches the result. If then, the 2-Year yields may be falling as the market digests worse-than-expected economic data, this could prove to be a benefit to the P/E for the market, with equities rallying in a ‘bad-news-is-good-news’ type of fashion. 

Traders who follow the E-mini Russell 2000 will know that it has struggled relative to E-mini S&P 500 futures. While that market has been solidly in the bullish camp for over a year, the E-mini Russell 2000 small-cap futures have really struggled to gain any traction. We can see that in the chart above which shows the generic front month E-mini Russell 2000 futures along with the 50-day and 200-day moving average.

Going back to 2022, one can see that as the futures broke below the 50-day moving average, a down trend was established and any rally even above the 50-day was kept in check by the 200-day. Over the course of 2023, as the E-mini Nasdaq and E-mini S&P 500 were rallying strongly, the E-mini Russell was churning in place, with the 50-day moving above and below the 200-day several times, failing to establish any sort of trend. Late in 2023, the futures moved above both moving averages and the 50-day crossed above the 200-day early in 2024. Since then, any pullback in the futures has been supported by the 200-day moving average, suggesting that the futures are trying to establish an uptrend. With the recent move back above the 50-day, we could perhaps be seeing the start of a trend higher, which may be supported by the expansion of P/E based on falling short-term interest rates.

Is there enough interest in the E-mini Russell right now or are traders focused much more on the E-mini Nasdaq and E-mini S&P 500, which have led the way? Well, there may be a catalyst of another sort that could serve to re-direct trader focus on the E-mini Russell futures.

We can see from the spikes in both volume and open interest, there is more interest in the E-mini Russell around the quarterly expirations. Looking back to last summer, we can also see that the volume and open interest steadily climbed, and the spike was larger, in June, when the Russell indices go through their annual rebalance.

Are we about to enter a period where traders focus on the Russell more ahead of the rebalance, which might get them to focus on the fundamental and technical triggers for a move higher? At the very least, the volume and open interest moves will get more eyes focused on this market and potentially not as much on the others. It is an opportunity where there will be a great deal of liquidity for the trader that wants to use this as a time to establish positions in the options market to take advantage of their directional views. 

Taking a look at the heat map of options on E-mini Russell 2000 futures, we see that the open interest is already beginning to move higher for the options that expire at the end of May and into June. The same pattern we witnessed last year, with the open interest climbing into a spike around the June expiration and end-of-month Russell rebalance, may be occurring again. This could present a great opportunity to use this open interest to establish positions, or to position oneself long convexity (optionality) to take advantage of trades that are occurring with the rebalance, as well as with any directional moves that could take place. 

My eye is especially drawn to the June expiration, where one can see open interest climbing – particularly on the call side of the ledger. Look at the open interest in 2200, 2250 and 2300 strikes, which really stand out. While not as large, there also appears to be accumulating open interest in the puts around the 1900 and 1950 strikes. These are the areas where I want to focus my attention as I look to design a strategy. 

How does this sentiment in E-mini Russell options compare to the last two years? For one, it appears that the combined open interest in puts and calls is at a recent peak vs. the last two years, as more options are being used to express views right now than at any time over this period. The yellow line in the second panel shows the ratio of puts to calls. This line is at the lows of the last two years, telling me that more calls are trading relative to puts. 

This is another way of saying that traders are positioning for a bullish move in the futures, with more trading being done in the calls. As option traders warm up to the E-mini Russell 2000, it may be only a matter of time before we see this start to happen in the futures market. This is another potential catalyst calling for a move higher.

While the volume has been increasing for calls relative to puts, it appears that the implied volatility for calls relative to puts, or the skew of implied volatility, is still more pronounced on the put side. In fact, the out-of-the-money call options are still trading at implied volatilities below the at-the-money options. For me, if I am looking to build a bullish E-mini Russell options position, seeing that I can still receive a discount for upside options is good news.

In addition, with a still healthy skew to the market, this may also be an opportunity to defray the cost of my strategy by selling downside options. I am ultimately going to look to design a strategy that would give me a better reward-to-risk structure than simply buying futures. The implied volatility skew suggests this could be possible.

I want to refer back to the open interest heat map. The place with the most open interest that I want to use to my advantage in developing my idea is near the 1950 strike on the downside and near the 2250 strike on the upside. Looking at the implied volatility skew, I should be earning a premium in implied volatility terms to sell the puts and buy the calls. Based on my assessment of the futures contract’s technical charts, I think a base may have been built that could lead to an upside move here in futures. The catalyst for this move would be a higher forward Price to Earnings ratio driven by lower short-term interest rates. These lower interest rates are a function of the weaker data markets have seen in the past few weeks.

All of this is coming together to suggest to me that I should sell puts and buy calls, but in choosing the strikes I have, and seeing there is skew to the implied volatility, I realize that I am able to do this in a ratio fashion. If I sell one of the 1950 puts, I can buy 3 of the 2250 calls and only have to pay about 3 ticks. Essentially, for close to zero cost, I can build a bullish options strategy where the reward to risk rivals that of a long futures position. Yes, I have risk to the downside that happens if we settle below the 1950 strike vs. the futures at 2069 right now. However, on the upside, I have leverage to move higher. Yes, my breakeven happens about at the 2250 call strike. But as illustrated in the expected return graph, the sooner this move happens, the better it works for me, as the leverage from the trade begins to pay off on any move higher. The longer it takes to happen, the more the graph will look like the payoff diagram.

I am counting on a move that happens sooner than later, as traders and investors begin to focus on the E-mini Russell ahead of both the next FOMC meeting on June 12, and ahead of the Russell rebalance at the end of June. There has been the pattern of increasing volume and open interest from May into June ahead of the rebalance and there typically is always quarterly expiration interest. The time may be right to put on a bullish position just as the rest of the market is starting to focus its attention on the E-mini Russell 2000 futures.

Good luck trading!

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