With all of the focus on the efficacy and trend of employment data and the distance from and trend away from inflation relative to any real or perceived FOMC target, one data point was somewhat glossed over when it came out earlier in August. This data point was the National Federation of Independent Businesses Optimism Index. Given 99% of businesses are small and these companies employ half of all workers, the state of conditions for small businesses is quite important for the overall economy. The data came in better than expected and extended a trend markets have seen since the lows near Liberation Day. In the top chart, I overlay this data vs. the generic front-month Russell 2000 futures. You can see a pretty good fit with the futures move being coincident, if not leading somewhat. The move in the Russell 2000 in the last week may indicate a further move higher in sentiment. Conversely, one might say that the futures have moved too far relative to the data. However, the bottom chart suggests otherwise. The bottom chart shows the relative performance of Russell 2000 vs. S&P 500 compared to this same sentiment data. In this analysis, one may surmise that the relative move in small-cap companies vs. their larger peers may only be starting. With the potential for allocation into small caps and out of large caps, or at least seeing new money coming into the market potentially preferring small caps, perhaps the move in Russell 2000 futures is only in its early stages.

Another way to assess if there are legs in this move higher comes from technical analysis. The top chart looks at the weekly Ichimoku cloud for Russell 2000 futures. The first thing that stands out is that Russell 2000 has gone sideways for the better part of four years. It has been in a pretty clear 1600 – 2400 range during this time, even as it moves higher. As markets such as the Nasdaq-100 and S&P 500 make new highs, traders can also see that the Russell 2000 has yet to make a new high. Perhaps this latest move will get to at least that level. On a third attempt to set a new high, could it happen? The bottom chart tells us whether there is exhaustion in the move. The daily Ichimoku chart highlights three things to me: 

1. The Ichimoku cloud itself has turned higher suggesting there is a new trend starting. 
2. The MACD has crossed over and turned higher, corroborating the view that there is a new trend. 
3. The RSI is not overbought, suggesting there are more legs to the move higher. 

While futures may look attractive technically, is the index attractive fundamentally? For this, I turn first to an earnings analysis.  While the results are not as positive as the S&P 500, there were positive surprises on both sales and earnings in the latest period. If one looks at the lower left, they can see that positive surprises on both are not the norm. However, over the last four quarters, the results are getting better and better. One should then ask – what may be driving improved results? It is likely not AI capex spend, which is driving S&P 500 earnings surprises. However, there are several other potential drivers of earnings in this quarter, but potentially moving forward as well. If we recall back to the post-election move higher in Russell 2000, the narrative surrounded rate cuts, lower taxes‌ and lower regulations. We saw the extension of the Tax Cut and Jobs Act, making lower taxes permanent for companies. The administration has worked to lower regulations in each agency, but maybe most importantly for smaller banks, which could free up capital for smaller companies. Finally, the market is pricing rate cuts to begin at the September FOMC meeting. Will we now see this narrative get fulfilled entirely? Is this the impetus for the move higher in the NFIB Optimism Index? Will Russell 2000 futures follow?

This string of betterthanexpected news is important, particularly when we take positioning into account. leveraged funds have their largest-short ever in Russell 2000 futures.  Whether this position is an active bet against small caps or a preference to hedge in a market less driven by AI, the short base creates dry powder for a move higher when one considers that there is both fundamental and technical rationale for a continued move higher in Russell 2000. On the right side of the chart, the short base went from short 50K contracts to long 50K contracts last fall, which coincided with the big absolute and relative move in Russell 2000. Now the short base is over 100K contracts, so even a move back to flat positioning could potentially lead to a similar 13% move that markets saw last fall which points to Russell 2000 futures over 2500.

Now turn to the volatility markets to see if options traders are positioning for a move higher. The first step is a comparison of implied and historical volatility to gauge whether there is a large spread or risk premium built in. Quite the opposite, in fact, as recent historical volatility has moved above implied volatility. At-the-money implied volatility has stayed pretty muted in the low 20s for the last few years with the exception of a pre-election spike and then the Liberation Day spike. After hitting 40 in early April, levels near 23 or 24, which is lower than the historical volatility, appear attractive and may argue for long gamma or long volatility ideas.

I also want to look at the implied volatility surface for options on Russell 2000 futures to see if there are any relatively high or low spots across the term structure for at-the-money options, or in the skew between puts and calls. I particularly want to focus near the bottom of this chart because these options will contain the next FOMC meeting on September 17. While the skew for puts over calls has been higher in the past, given that Russell 2000 has lagged the S&P 500 by so much, and that there are positive catalysts ahead, I still think it benefits traders to take advantage of any positive skew for downside options vs. upside options, particularly near the expiration that contains the next FOMC meeting. The best contract for this is the R3EU5. The lower delta skew tends to be more steep than the 30 delta skew, which is less than two volatility points. For example, 15 delta skew is more than double that at almost four volatility points and given a 15 delta call should have some kurtosis features vis a vis a 30 delta call, I think this may be an opportunity.

Putting all of this information together, I want to put on a bullish option structure in Russell 2000 options. I look to the expiration that contains the FOMC meeting because I think not only the reality of rate cuts, but the discussion of potentially more rate cuts are a key catalyst for a bullish move. Volatility is not demanding and if there is a move to and through the all-time highs, I might expect to see implied volatility benefit relatively speaking. There is fundamental and technical support for a bullish move; it may just need this catalyst to draw investor attention away from large-cap indices and into smallcap indices. An important consideration for me is the extremely large short base in Russell 2000 futures. I read this to mean that moves lower will see profit-taking buying and moves higher could potentially see short-covering. As a result, I am comfortable to sell 2300 puts which sit right at the top of the Ichimoku cloud where leveraged funds might want to cover some short. The 2400 calls sit below the all-time high, and as futures move higher, I think the all-time high, hit back in 2021 and again in late 2024, comes into focus. Because I chose lower delta options, the skew is favorable, which enables me to sell 1 2300 put and use the premium to buy two of the 2400 calls, giving me more leverage to an upside move that I can get from futures alone. Doing the trade at roughly zero cost gives me more staying power versus buying calls outright, though with implied volatility in line with historical volatility, simply buying the 2400 calls may make sense too. I prefer the incremental leverage I can get in a zero-cost idea. The risk, of course, is a move lower, especially a sharp move lower. I do think the move lower would see some speed bumps because there is already such a large short base; however, a trader would need to be prepared to either cover the short 2300 puts at a loss or sell futures against the overall position if the catalyst does not play out as expected or if there is new information that drives futures lower.

There are many things lining up for a trade here that one doesn’t always see: macro data, company data, technical charts, positioning, volatility markets. That potentially could mean an asymmetric outcome.

Good luck trading!

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