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Small-cap U.S. stocks, which have been lagging their large-cap peers all year, surged more than 5% Tuesday, after October’s CPI data showed inflation cooling at a faster pace than expected. I like to utilize the iShares Russell 2000 ETF (IWM) which seeks to track the investment results of the Russell 2000 index, measuring the performance of the small-capitalization sector of the U.S. equity market. The lagging index chalked up its best day since November 2022, when it rose over 6%. I believe that this is just the beginning for small caps recovering. Small caps have been struggling versus their peers as a rising interest rate environment has absolutely punished these growth companies. The Russell 2000 ETF is finally positive in 2023 and now up just over 3% year-to-date, versus a 17% pop for the large-cap S & P 500 ETF (SPY) and a sensational 45% surge for the tech-heavy Nasdaq-100 ETF (QQQ) . My thesis of small caps finally getting up off the mat is based upon my recent and lonely call of U.S. Treasury yields relenting. The 60-basis point drop in the 10-year yield (5.02% down to 4.42%) has unilaterally brought down borrowing costs for consumers as well as small market capitalized constituents of the Russell 2000. (1 basis point equals 0.01%.) These lower rates are like rocket fuel for these oversold and unloved companies. So, will small caps recover or was this a one-day pop you ask? As long as U.S. Treasury yields remain off their highs and expectations are for the Fed to be on pause for the foreseeable future, the answer is yes. In addition, I have repositioned my model portfolios’ exposure to include small caps for the remaining six trading weeks of 2023. A risk reversal The option strategy that I want to utilize to potentially gain exposure to small caps is via a zero-cost spread. Better known as a risk reversal, but instead of usually putting this spread on for a credit, I am putting this on at no-cost as the upside call is more expensive than usual, aka the call is “bid”. “Bid” meaning that I am not alone in this idea of small caps finding some legs between now and the end of the year. This approach has risk in owning the underlying by possibly being assigned to the put being sold. However, I am willing and comfortable owning small caps at this level since there is a nearly 20% difference in IWM and SPY from the market low back in October of 2022. This zero-cost spread can be established by selling an out-of-the money put and using the premium collected in writing that put option to buy an upside OTM call for the same price. The same expiration will be used for both the put and the call options. Looking at a chart for 2023, I believe that the January and July highs of $198 could be revisited if IWM can close above its 200-day moving average at $181.23. Risk Reversal specific to the iShares Russell 2000 ETF (IWM): Sold the regular expiration December $175 put for $2.20 (which is a little more than 2% lower from Nov. 14 close) Bought the regular expiration December $185 call for $2.20 The result in the sale of the put and the purchase of the call results in zero cost for this bullish spread A risk reversal strategy involves buying an out-of-the-money call and selling an out-of-the-money put. You want IWM to go above your long call strike as much as possible. You have unlimited profit potential to the upside, but you also have unlimited downside risk too. Generally, the advantage of a risk reversal is putting on a bullish position with a long call, but by spending very limited cash upfront (in this case, zero cash upfront) because you are financing the purchase with the sale of a downside put. Aggressive bull trade Typically, a risk reversal is a hedging strategy that protects a long or short position by using put and call options simultaneously. This strategy can protect against unfavorable price movements in the underlying position but also limits the profits that can be made on that position. If an investor is long a stock or ETF, they could create a short risk reversal to hedge their position by buying a put option and selling a call option. This risk reversal is being used as an aggressive bull trade. Since I am buying a higher strike price call option and financing the premium paid by selling an out-of-the-money put option, I am essentially putting on a bull trade for no cost. If I am correct, and IWM continues to recover higher, the short put will become worthless, and the long call will increase in value — generating a considerable profit. However, if I am incorrect about small caps recovering, I will be forced to buy IWM at the short put strike price minus the premium collected. In this case, I would own IWM at $175 as I collected $0.00 on the spread/risk reversal. This strategy is considered risky and can generate significant losses, all short puts should be cash covered. Being forced to buy IWM lower is still a better outcome than if I would have simply purchased the ETF outright at $179. DISCLOSURES: (Long IWM and the options spread.) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. 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