Signal du Jour - IWM - Sharpe 2.01 Win Rate 74%

The markets are dancing - let’s play musical chair.

The markets have been buzzing with nervous energy lately, and daily reversals have become the norm. Yet the indices seem hesitant to take a definitive path. Flirting with the year’s highs with an occasional glance towards a pullback - this has been the tune on which traders have been dancing the past few weeks.

When is this going to end? Only the market’s Gods know.

At Sharpe Two, we keep trusting in the data right before our eyes, and today, it looks like a divine opportunity has emerged. As the market eagerly anticipates the final employment report of the year and the subsequent Federal Open Market Committee (FOMC) meeting, things may likely remain just as they are - shaky and groovy, but never too far from the punch bowl.

Didn’t Prince (not the glorious singer, but the infamous banker) say - you must dance until the music stops?

So dancing we are.

The context

As we near the end of an exceptional year, fund managers are actively rotating their portfolios. And while the Nasdaq has been the unchallenged 2023 Prom’s Queen, SP500 and Russell 2000 are now doing everything they can to steal the show.

IWM outperforms SPY and QQQ

The Russell 2000 (ETF symbol IWM), tracking a broader range of mid-sized US corporations, is outperforming the SPY (tracking the S&P 500) and the QQQ (ETF for the Nasdaq).

This is partly due to the remarkable 43% rise in the QQQ this year, compared to a more modest 18% for the S&P 500 and just 7.5% for the IWM. This scenario suggests a shift from the tech sector to the real economy, especially with higher interest rates impacting the profitability of technology companies.

However, this provides just a backdrop. The whole story is that the IWM and other indices took a hit in September and October when it was all about the Fed and its rate policy. When things looked dire, and it became clear that the rate wouldn’t move before somewhere in 2024, investors swooped in, buying at a record pace. All that action sent IWM’s historical volatility to heights last seen in March amid the regional bank crisis.

Historical volatility in IWM is at the year’s highs.

Such dynamics contrast with the recent calm, though. And, despite some wild intraday swings, the major indices have been stuck in a rather uneventful, narrow range.

Given this, we focused on how the options markets reacted to these contradictions - dramatic intraday movements but no significant end-of-day changes. Indeed, we anticipate that the implied volatility in IWM is higher than the realized moves.

The signal and the trade methodology