Amid October Rally, Small-Cap Volatility Wanes

After slumping during the third quarter, U.S. stocks have started the fourth quarter with a bang as the S&P 500 has surged 6.8 percent. Though lagging the S&P 500, some major small-cap benchmarks are getting in on the act as well.

For example, the iShares Russell 2000 ETF (NYSE:IWM), the largest exchange traded fund devoted to smaller stocks, is up 5.2 percent since the start of the fourth quarter. One thing that is not accompanying the small-cap rally: volatility. Yes, IWM has been more volatile than the S&P 500. The small-cap ETF is sporting fourth-quarter volatility of 20 percent compared to 13.7 percent for the S&P 500, according to ETF Replay data.

Still, data suggest small-cap volatility is waning this quarter and doing so in significant fashion.

"Small-cap market volatility measures have told a different story this October to-date. As of October 16, the average closing price for the CBOE Russell 2000 Volatility Index (RVX) is 20.74, well below its long-term average closing price of 25 and significantly below the long-term average closing price in October of 29," according to FTSE Russell, the index provider behind IWM.

Waning volatility is encouraging some investors to jump into small-caps. Month-to-date, IWM has added over $959 million in new assets, a total exceed by just one other equity-based ETF and just five ETFs overall. To this point in the fourth quarter, IWM is the top asset-gathering U.S. equity ETF.

Dwindling small-cap volatility could be causing another phenomenon: Forced covering of bearish positions by short sellers. As Benzinga reported Thursday, short-sellers have covered more than $500 million of positions in IWM this month according to research out yesterday by S3 Partners Managing Director of Research Ihor Dusaniwsky. Among major broad market ETFs, only the SPDR S&P 500 ETF (NYSE:SPY), the world's largest ETF, has seen more short covering this month.

"We are in an unusually calm period for US small-cap volatility. In addition to the current RVX level being low relative to the long term history of the Index, low volatility in October is anything but the norm. In fact when considering the monthly average close, October has the highest average close for RVX. The chart below shows the average closing level by month for RVX from 2004 through 2014. October stands out with an average of 29.08 and November comes in No. 2 at 28.43," said Options Institute at CBOE Director Russell Rhoads.