The Opportunity in the Market's Small Cap/Large Cap Divergence

Despite the exuberance of the recent World Cup and Brazil’s increased economic prosperity and stability over the past decade, what has happened under the canopy of soccer euphoria is a much different picture. By now we’ve all seen the uprisings led by the nation’s oppressed population that for months had been kept out of the mainstream media.

The tension beneath the surface is analogous to the heightened levels of volatility within small-cap companies, which has been hidden beneath a steadily appreciating broad equity market—our topic for this month’s commentary.

Looking at the equity scorecard, the S&P continues its march to new highs, now up 5.7% year-to-date and up 39.8% since the beginning of 2013. In addition, the NASDAQ closed within 2% of its highs last week.

On the volatility front, equity volatility remains subdued, with the VIX holding steady between 10 and 13 on a daily basis. While it appears like a simple case of equities up and volatility down, parts of the equity markets began to diverge recently. Higher-risk equities, specifically small caps, high P/E technology and high P/E biotech stocks sold off significantly versus the S&P 500 starting in early March. 

A likely catalyst for the move down was negative earnings announcements from market darlings like LinkedIn and Tesla, which led to strong downside pressure on the frothiest equity names.

From March 1st through May 30th the performance of IWM (an ETF that tracks the Russell 2000 Index), was -3.72% while the S&P 500 returned +3.89%. However, peak to trough, the total divergence was closer to 8.5% (see chart 1 below).

Underperformance of this magnitude is quite interesting and fairly rare. The only occurrence of this significance in the past 10 years was in August 2011. Interestingly enough, the VIX was at 40 in August 2011 versus 12 today!

While one could argue that the small/large cap divergence was ripe for a reversion to the mean given small-cap outperformance in 2013, the speed at which this correction took place is most remarkable. 

From an options perspective, this dislocation caused many market participants to scramble to buy put protection on their technology and small cap portfolios.

The increased demand for protection caused option prices in certain ETFs (IWM and QQQ, for example) to increase dramatically while S&P Index option prices barely budged. Chart one below demonstrates where these options traded relative to the historical IWM/SPY volatility relationship.

Click to enlarge

Over the past five years, the ratio of IWM implied volatility to SPY implied volatility (IWM/SPY) has averaged roughly 1.34x. In March of 2014, this ratio reached 1.65x. While this difference in ratios seems small on the surface, we see that this is about four standard deviations from the normal relationship and remains quite stretched today (See chart 2 , bottom right).

Click to enlarge

The potential opportunity created was two-fold.

First, someone could simply buy IWM and sell SPY looking for this relationship to reverse. As long as the investor was comfortable being long small-cap beta and short large-cap beta.

More interesting to us is the potential opportunity in the options market. The option price divergences (exhibited via implied volatility) highlighted above created a pair trade opportunity to sell IWM volatility (which would profit from a decline in elevated volatility) and purchase SPX volatility (which would profit from a rise in SPX volatility from subdued levels)

In conclusion, though there seems to be complacency as broad equities make all-time highs, underneath the surface, it has been much more turbulent than the naked eye would see. Not unlike the unrest in Brazil that simmered beneath the glow of the 2014 World Cup, the equity markets could be signaling reason for caution.

For options and volatility traders, this turbulence might just create interesting trade opportunities.

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