2 ETFs to Deliver Double-Digit Gains from the Small-Cap Meltdown

Bigger isn’t necessarily better, but over the past six months, the bigger the market capitalization, the better the investment results.

For example, during that time, large-cap stocks in the broader S&P 500 index have scored a 7.4% gain. By comparison, small-cap stocks comprising the benchmark Russell 2000 index are actually down 4.2% since late March.

#-ad_banner-#In Monday trade, the declines in the small-cap segment of the market got rather ugly, and the Russell 2000 sank 1.4% for its biggest one-day loss in seven weeks.

The divergence between the large-cap and small-cap segments of the markets is a worrisome development for a continuation of the bull market, as it signals a clear breakdown in market breadth. Moreover, the slumping small-cap segment usually is a precursor to a wider sell-off.

Interestingly, during the beginning of a bull market, small-cap stocks tend to lead the charge higher. This is because the smart money is generally more willing to take a chance on smaller, less-proven and more speculative small caps at the onset of a bull. Unfortunately, the reverse effect is also true, and that means that toward the end of a bull market, the smart money tends to flow to bigger, battle-tested and less speculative large caps.

Now, I am not saying that the roughly five-year bull market we’ve enjoyed is coming to an end. Nobody can say that until after the fact. What I am saying is that the six-month selling in small caps relative to their larger brethren can be viewed as a bearish harbinger for things to come.

Fortunately, the small-cap slide is something smart traders can take advantage of right now, and with two exchange-traded funds (ETFs) that move in the opposite direction of the Russell 2000 index.

ProShares Short Russell 2000

The first way to participate in the small-cap sell-off is via ProShares Short Russell2000 (NYSE: RWM). This fund is designed to deliver traders the one-to-one inverse performance of the Russell 2000. That means that if the Russell 2000 falls 2%, then RWM will rise 2%.

The chart here of RWM reflects the recent surge in the fund as a result of the small-cap weakness. RWM already had breached its 50-day moving average, and in Tuesday trade, the fund broke above its 200-day moving average. The technical move here augers well for continued gains in this inverse small-cap fund, so if you want to add a little trading hedge to your current portfolio, then this one should be good for at least another 5% upside over the next six weeks.

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Recommended Trade Setup:

— Buy RWM at the market
— Set initial stop-loss at $16.08 (5% below current prices)
— Set initial price target at $17.78 for a 5% gain in six weeks

ProShares UltraShort Russell 2000 — The Leveraged Option

For more aggressive traders looking to both hedge their current longs and make some potentially big short-term gains off the continued weakness in small caps, there is the ProShares UltraShort Russell2000 (NYSE: TWM).

Like its less-aggressive compatriot RWM, TWM moves in the opposite direction of the Russell 2000. The difference here is that TWM uses futures contracts to leverage its returns. So, if the Russell 2000 falls 5%, then TWM should deliver gains of 10%. The two-to-one leverage you get with TWM can translate into a big win in your trading portfolio if you get the timing correct.

The chart below shows the spike higher in the fund since its six-month low in July. It also shows the surge back above the 50-day moving average this week, and is nearly back above its 200-day moving average.

If you’re an aggressive trader looking to double down on continued weakness in small-cap stocks, I think TWM can bank a 10% gain over the next six weeks.

Finally, when shorting stocks with ETFs such as RWM and TWM, I like to keep my stop-losses tight. The past five years have taught us that it isn’t too smart to bet against the bull for an extended period, so if you’re going to do so here as a short-term hedge and/or way to juice returns, then make sure you have a protective stop-loss firmly in place.

Recommended Trade Setup:

— Buy TWM at the market 
— Set initial stop-loss at $43.06 (10% below current prices)
— Set initial price target at $52.61 for a 10% gain over the next six weeks

Note: My colleague Amber Hestla has closed 66 straight winning trades using a put selling strategy. See her first 52 winners and learn exactly how you can make the same profitable trades by following this link.

This article was originally featured on ProfitableTrading.com: 2 ETFs to Deliver Double-Digit Gains from the Small-Cap Meltdown