Options Trade: Set Up in the Russell 2000 ETF

The Current Dynamic

The bond market is telling investors that the tax agreement, agreed to by the Obama Administration and the Republican Congress, is going to increase growth, and generate higher consumer participation in the economic rebound.

A consumer jolt will press GDP higher, and spur on higher interest rates and higher asset prices. The equity market is not completely convince that there will be a powerful rebound in store for the US economy. Bond prices are artificially higher, as the Fed QE program is targeting the 10-year duration on the interest rate curve.

The range for the 10-year note future is likely to be between 127.00 and 116.00. The monthly Bollinger bands have encapsulated the risk on the 10-year note, with support coming in near 121.24, 120.13 and then 116.00. Resistance is slightly above 127.00 at 127.11.

If the FOMC is successful in pushing the 10-year note back to 127.00, which is nearly 50 basis points lower, the equity markets will press higher, and the dollar will sell off.

Historical Relationships

The intertwine nature of the markets at this time is different than the norm. Historically, the Federal Reserve was fighting inflation and inflation expectations, and kept rates in position to maximize growth while limiting inflations. Housing and labor are very important to the inflation calculation, and the low level of these prices convinces the FOMC that they can put the pedal to the metal, and step on the breaks when those markets start to heat up.

By the time the Fed steps on the breaks, equity markets will be higher, Precious Metals, Base Metals, and the majority of the commodity base will be much higher.

The Trade

The ETF for the Russell 2000 Small Cap Stock Index (NYSE:IWM), has broken out on a weekly basis. The target for IWM is resistance at $86, which is 10 points higher or 13%.

On a daily chart, the breakout level is $2 below current trading activity, which could mean that the IWM will test the break out level near $74, before resuming its climb toward $86.

The Risk

Bullish upside views in the equity markets and commodity markets can be levered by using a collar. This is where you purchase a “out of the money” call, and finance it buy selling an “out of the money put”. The risk to your trade is that interest rates in the US continue to back up, and the 10-year note moves down another 5 big figures which is close to another 40 basis points.

Strategies

There are three strategies that will capture that upside in IWM.

1) – Call Spread – Purchase a February 80 Call ($1.42 Premium) and simultaneously sell a February $85 Call ($0.30 Premium) – This strategy will cost you $1.10 for the structure – which has an upside of $5 dollars. The risk reward ratio is more than 4:1 and your downside is capped at $1.10 per contract – (each contract is 100 shares of IWM).

2) Collar – Purchase a February$ 80 Call ($1.42 Premium) and simultaneously sell a $71 put ($1.42 Premium). This collar is zero cost, meaning that you will not have any premium outlay. If you believe $71 is to close for comfort, you can sell a $65 put, which will allow you to collect $0.55, and the structure would cost $0.87 cents.

3) Add a sold put to your call spread. Number 1, above costs $1.10, and with a $$65 put added (that is sold), the cost of the structure would be $0.55 cents.

Research: Check out our high tech stock research tools for IWM >>

Disclosure: No positions.

David Becker writes for Option Strategies Guide.