3 Indicators Predict a Sell-off That Could Make Traders 87%

Jared Levy's picture

Wednesday, October 22, 2014 - 7:30am

by Jared Levy

The small-cap Russell 2000 is officially in a correction, falling as much as 12% from its September high. Even after this big drop, my analysis uncovered three major indicators that point to another double-digit decline. 

While any one of these on its own would be enough to justify a bearish trade, the fact that all three are in agreement makes for a uniquely compelling case. And with today's strategy, traders can use the iShares Russell 2000 (NYSE: IWM) to leverage that decline into 87% potential profits in five months or less.

Indicator No. 1: Stats are Not on the Russell's Side

Bull markets are said to occur when equity indices climb at least 20% over a period of several months or more, usually during a period of economic expansion. Since the Great Depression, only one bull market has lasted more than a decade, with the average length around three years. The average return of the Dow during a bull market period is about 140%, and the median return is around 90%.

We are now five and a half years into the current bull market with the Dow up 151%, the S&P 500 up 180%, and the Russell 2000 up 220% since the 2009 lows, even after the sell-off from recent highs.

All of those statistics are outside the average time and percentage gain of the typical bull market and would cause the average statistician to expect a mean reversion (i.e., correction). Add in the fact that this is one of the weakest economic recoveries in history, and the bearish argument strengthens.

Investors often look to the Russell 2000 as the "canary in the coal mine," as it tends to lead the bigger indices up and down. If you're a believer in that theory, which I am, you should take notice that the index has been the clear laggard in 2014, off 6% year to date, after screaming 37% higher in 2013.

Finally, during the most recent major correction in 2011, the Russell 2000 lost 30%. The 12% decline we've witnessed from the September highs may just be the beginning. 

Indicator No. 2: Unrealistic Price-to-Earnings Multiple

Back in July, Federal Reserve Chair Janet Yellen specifically called out small-cap valuation as an area of concern. 

The Russell 2000 is trading at about 70 times trailing earnings compared with 18 for the broader market S&P 500.

Due to the fact that the Russell 2000 is comprised of smaller, growth-oriented stocks, it earnings multiple is typically higher. However, it now stands 75% above its historical average price-to-earnings (P/E) ratio of about 40, while the S&P 500 is only 20% higher than its historical average of 15.

If the economy was growing at breakneck speed, consumer confidence was through the roof and we weren't more than five years into a bull market, I might give the high P/E a mulligan. But not with GDP growth slowing, the Fed wrapping up its bond-buying program, and investors moving money out of riskier stocks and into more defensive havens like bonds, blue chips and even cash.

Indicator No. 3: Technical Breakdown

The technicals paint a very bearish picture for small caps. 

IWM Chart

IWM is in a bearish channel with five resistance points standing between it and a move back into bullish territory. That's three Fibonacci levels and two major moving averages it would have to overcome. That's quite a feat and highly unlikely given the fact that the Russell tends to respect technical barriers.

The coup de grace for the bears is the "dark cross" (also known as a death cross) that was triggered on Sept. 22. This highly bearish event occurs when the 50-day moving average falls below the 200-day. It signals a major reversal in trend from bullish to bearish. 

A recent study by Bank of America/Merrill Lynch examined the dark cross and its effects on the Russell 2000. The latest dark cross marks the longest period between a bullish golden cross (50-day moving average crosses up through the 200-day) and a dark cross going back to 1978. 

Following the second longest streak (from May 1997 to September 2000), the index was 13% lower six months after the bearish signal. It is currently off just 3% since the latest dark cross was triggered.

Being that the recent bullish streak was the longest in history for the index, I think it's highly probable that the bearish trend that ensues will exceed the losses of the previous dark cross signal. I am looking for a move to $96 in IWM, 14% below the close on the day the it was triggered.

IWM Put Option Trade

Today, I am interested in buying IWM March 115 Puts for a limit price of $10.15.

IWM Put Option
Risk graph courtesy of tradeMONSTER

This put option has a delta of 65, which means it will move roughly $0.65 for every dollar that IWM moves, but it costs a fraction of the price of the ETF.

The trade breaks even on expiration at $104.85 ($115 strike price minus $10.15 options premium), which is 4% below current prices.

If IWM hits my downside target of $96, the put options will be worth at least $19. Once you enter the trade, place a good 'til cancelled (GTC) order to sell your calls at that price.

Recommended Trade Setup:

-- Buy IWM March 115 Puts at $10.15 or less (use limit orders)
-- Set stop-loss at $3
-- Set price target at $19 for a potential 87% gain in five months 

Note: While this trade calls for buying IWM puts, selling puts can be a profitable strategy as well. In fact, selling puts one of the best strategies for generating consistent, market-beating returns. My colleague, Amber Hestla, has generated 54.5% average annualized gains with this strategy on her way to a perfect 66 for 66 track record. You can learn exactly how to make the same trades -- plus details about her first 52 successful trades -- by following this link.

This article was originally published on ProfitableTrading.com: 3 Indicators Predict a Sell-off That Could Make Traders 87%

Jared Levy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.