Saturday, February 16, 2008

Trading Options in the Russell 2000

I'd be interested to here from anyone in the UK that trades options in the Russell 2000(^RUT). Currently I trade using using IGIndex but their list of options is limited and doesn't include the ^RUT.

There are a couple of good reasons for buying put options on the ^RUT that I can see.

Firstly the ^RUTs P/E ratio is currently higher than most other indices. It's hard to find good quality figures for the PE but there are some (conflicting) figures out there...

The Wall Street Journal gives a figure of 40 based on trailing earnings.

The home site of the Russell indices gives PE ratios ex-negative earnings. Which IMHO is a pretty meaningless figure, but at least we know the true PE is no lower than this figure, currently quoted at 17.59.

The IWM is an ETF based on the ^RUT, and google finance gives us PE ratios for the ETF of 5.59

Forbes though quote 86.3

And here's yet another figure from July 2007 (40.82):

Quite a mess huh. Another handle on this is to look at the yield, since dividends are (mostly) paid out of earnings. Figures for the yield are a little more in agreement and I take the figure from to be about right, that being 1.35%. If all earnings were paid out as a dividend that would give a PE ratio of 74. Ok, so we can safely say that the true PE (based on trailing earnings) is between 17.59 and 74.

My own belief is that the true figure for trailing earnings is around 40. Jeremy Grantham at GMO has briefly mentioned shorting the Russell a couple of times in his quarterly "Letters to the Investment Comittee" that can be downloaded from His argument has been that the ^RUT is a good proxy for small to midcap stocks, which have outperformed large cap stocks since 2003. In times of falling profits it will probably be the blue chips that do well owing to their greater exposure to international trade and existing capital investment and infrastructure. A flight from riskier (lower or no profit) stocks to less risky stocks (good profit margins) would suggest a shift away from the Russell 200o to larger companies and thus indices such as the S&P500, Russell 1000 or the Dow. Indeed the recent falls have been more pronounced in the ^RUT than those other indices.

Essentially there is further down to fall for the ^RUT so we can expect more profts from buying puts or shorting as the PE reverts to mean. The next question then would be - What is the mean PE for the ^RUT?

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