Trade Update – $XHB: Spreading Put

by Dan January 27, 2014 1:12 pm • Commentary

With XHB bouncing off its 200 day moving average today, we’re going to take the opportunity to spread our Long March 32 put that we bought on Friday Jan 17th (below):

ACTION – Sold to open the XHB ($30.80) March 30 put at .70
New position – long the XHB March 32/30 put spread for .35



Original Post Jan 17th, 2014:  New Trade $XHB: Home Slice

Homebuilding-related stocks got off to a red-hot start in 2013, with XHB rising more than 20% in the first 5 months of the year.  Since May 2013 however, when rates began their taper-spurred rise, the ETF has lagged the broader market, and is down more than 3% to start 2014.

U.S. interest rates have held relatively steady for the past 6 months, but banks this week reported steep declines in mortgage originations, with continued weak demand expected for 2014.  The 30 year mortgage rate was around 3% a year ago vs. 4% today, and that has naturally reduced the demand.

Putting aside reduced mortgage demand, we’ve received several more concerning signs about domestic demand in the past month:

1.  Holiday Sales Weakness.  The retail stock misses have piled up, but our main concern has been the drastic stock reactions, as we noted in yesterday’s Morning Word:

Stocks naturally anticipate the future, so when they start to make big, impulsive moves lower, investors are not only pricing in today’s news, but potentially more negative future implications as well.  If the economy is struggling, the macroeconomic indicators might not show it for 6 months.  But the stock market reaction will be much earlier, and much swifter. Especially if valuations are projecting a much more rosy future, as seems to be the case with many of the retailers reporting holiday numbers.

2.  Auto Weakness.  Both Ford and GM have reduced 2014 guidance over the past month, and the AutoNation CEO stated this week that inventories were likely piling up at U.S. dealers after heavy purchasing for the new year.  GM and AN were both lower on big volume on Wednesday as a result.

While macro-economic data in the U.S. has been decent, corporations are signaling increased difficulty in selling to consumers.  So if the backdrop is one of tepid consumer demand during the holidays, falling demand for the largest durable goods purchasing (autos), and higher rates hindering the housing market, shouldn’t we expect weakness in homebuilding and construction-related stocks and retailers?

The XHB ETF is not really a homebuilder ETF, which irks some who want pure exposure to the housing market.  But for our purposes today – to fade homebuilding-related stocks and retailers – the ETF actually fits quite well.  Companies like Whirlpool, Home Depot, Tempur Sealy and La-Z-Boy are likely feeling pain too (Select Comfort and Bed Bath and Beyond have already reported weak earnings).  The cherry on top is that XHB’s implied volatility (and hence options prices) is near 2 year lows:

XHB 30 day implied volatility, Courtesy of LiveVolPro
XHB 30 day implied volatility, Courtesy of LiveVolPro

Add it all up, and here’s the trade:

Trade: XHB ($32) Bought March 32 Put for 1.05

-Bought 1 March 32 Put for 1.05

Break-Even on Mar Expiration:

Profits: below 30.95 make 1 for 1 with the stock, no max gain

Losses: between 30.95 and 32, lose up to 1.05, max loss of 1.05 above 32

Trade Rationale:

This structure takes advantage of the low implied volatility in XHB.  It does risk time decay as expiry approaches, but since March expiry is 2 months away, the trade won’t decay much for the next few weeks. XHB experienced a falls breakout above the $32.50 level (detailed in our Morning Word post last week), making a move down to the $30-$30.50 support area more likely in the coming weeks.