Traders are loading up on options as the Russell 2000 Index (RTY) hovers near the first 10 percent decline since 2012.
Demand for protection against further losses has pushed the Chicago Board Options Exchange Russell 2000 Volatility Index up 11 percent this year to 19.53. That’s the highest level since 2007 versus the VIX gauge of Standard & Poor’s 500 Index contracts. In the past three days, more than 1 million options traded on an exchange-traded fund tracking small-cap shares.
About $170 billion has been erased from the value of smaller U.S. companies since March as investors fled stocks with the highest valuations. Overstock.com Inc. (OSTK:US), Gogo Inc. and American Apparel Inc. have seen at least half their market value disappear this year. The Russell 2000 is 1.8 percent away from completing a 10 percent retreat, also known as a correction, since its March 4 record.
“Small-caps got aggressively priced and crowded,” Todd Lowenstein, a fund manager who helps manage $16 billion at Highmark Capital Management Inc. in Los Angeles, said in a May 9 phone interview. “Given the nosebleed valuations we’ve had, I’d be nervous if I was a small-cap investor.”
The Russell 2000 rebounded at the end of last week, paring its drop from the past five days to 1.9 percent. The gauge is down 4.9 percent for 2014.
The losses have mirrored declines in technology shares and companies that recently went public. Groupon Inc. sank 15 percent last week after the e-commerce retailer forecast growth that trailed analysts’ estimates and Twitter Inc. lost 18 percent as early shareholders sold shares after a lock-up period expired.
Trading in options, often used to protect the value of stock holdings, has increased as equities declined. A daily average (IWM:US) of 878,000 contracts changed hands on the iShares Russell 2000 ETF last week, compared with 629,000 a year ago.
Shares in small-caps are still more expensive than their larger counterparts, even amid the selloff. The equity index trades at 20.3 times estimated earnings, compared with 17.2 for the S&P 500, the data show.
Puts on the iShares Russell 2000 ETF make up eight (IWM:US) of the 10 options with the highest ownership, data compiled by Bloomberg show. There are more than two bearish options outstanding for each call.
The retreat in small-caps shares will eventually reverse because the bull market isn’t over yet, according to Philippe Gijsels, chief strategy officer at BNP Paribas Fortis. Federal Reserve Chair Janet Yellen said last week that the central bank must continue to spur economic growth as indicators for inflation and employment remain far from the central bank’s goals.
“Small-caps were very much overextended,” Gijsels said in a May 9 phone interview from Brussels. “We’re seeing a healthy correction, but I think they will eventually go higher.”
Hedge funds and other large speculators are betting $3 billion that the Russell 2000 will fall, according to data from the Commodity Futures Trading Commission on Bloomberg.
The cost of bearish options (IWM:US) on the iShares Russell 2000 has risen. Puts protecting against a 10 percent decline in the ETF cost 8.67 points more than calls betting on a 10 percent rally, according to three-month implied volatility data compiled by Bloomberg. That’s up from 7.03 in November.
“The big question in the market right now is about the overextension of small-caps,” Michael Purves, chief global strategist at Weeden & Co. in Greenwich, Connecticut, said in a May 6 phone interview. The jump in options prices “reflects the thought that the selloff will continue.”
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