Small-caps rally ignites options frenzy, but strategists urge caution

By Saqib Iqbal Ahmed

NEW YORK (Reuters) - U.S. small-cap stocks' long-awaited rally has ignited record trading in options contracts that would benefit from their persistent strength, though some strategists say further gains could be limited.

The small-company focused Russell 2000 is up 9% over the last 10 sessions while the tech-heavy Nasdaq 100 has slipped 3% over that period in a market rotation fueled by expectations of interest rate cuts and the improved fortunes of Republican presidential candidate Donald Trump.

The small-cap rally has been accompanied by a rush into bullish options. A record 1.35 million call options on iShares Russell 2000 ETF changed hands daily over the last 10 days, Trade Alert data showed.

The trade has faltered more recently as tech stocks came roaring back on Monday, and some analysts believe small stocks may struggle to make further headway after this month's explosive rally.

Similar rotations have not had much traction the last couple of years, said Joe Mazzola, director of trading and education at Charles Schwab.

The Russell 2000's one-week percentage gain outstripped that of the Nasdaq 100 by at least 5 percentage points only three times over the last two years. In each instance the tech index soon regained the advantage, a Reuters analysis showed.

In the most recent example in late 2023, the Russell 2000 climbed 22% from November through December on expectations of rate cuts, but struggled to advance further when the cuts did not materialize.

The fundamental macro picture does not point to a sustained rally and the ongoing earnings season may be a litmus test, Barclays derivatives strategists said in a note on Tuesday.

Some investors see small caps as a market sector that could benefit from lower interest rates. Trump's political agenda, with tariffs on imports and lower taxes, is also broadly viewed as friendly to smaller companies.

Megacaps Tesla and Alphabet are set to report earnings later on Tuesday, with positive results having the potential to sooth investor nerves and reignite the tech rally.

(Reporting by Saqib Iqbal Ahmed; Editing by Ira Iosebashviliand Richard Chang)