New Trade $XLK: Lay-away Trade For a Tech Breakout

by Dan February 28, 2014 2:56 pm • Commentary

The Nasdaq Composite is trading back at levels it has not seen since the year 2000, just before the index was about to enter a very dark period where it would lose almost 80% from its peak to its trough in 2002.

Nasdaq Composite Since 1990 from Bloomberg
Nasdaq Composite Since 1990 from Bloomberg

In hindsight it is easy to call the speculation of the late 90s in tech stocks a mania, but with the index once again approaching those lofty bubble heights it is a much broader rally with far more reasonable valuations of its largest components, oh and there are hefty profits this time around.

When looking to trade the Nasdaq I go back and forth between looking for the broadness of the QQQ and the narrowness of the XLK (the SPDR Technology ETF).  For today’s trade I want to use the XLK because I want to focus on a narrow slice of meg-cap tech and telecom stocks and avoid the biotech and and consumer names that are prevalent in the Nasdaq Composite.

The top 10 components of the XLK make up about 60% of the ETF (below).  While many of the Nasdaq momentum leaders over the past year are at nosebleed valuations, most of the tech stocks that make up the majority of XLK would be better characterized as value rather than growth names:

Stock  % weight 2014 Retrun Div Yield
 1 AAPL           13.27 -6% 2.31%
 2 GOOG             9.57 9% na
 3 MSFT             8.04 2.25% 2.93%
 4 VZ             5.52 -3% 4.45%
 5 IBM             5.29 -1% 2.05%
 6 T             4.75 -9% 5.74%
 7 ORCL             3.84 2.25% 1.23%
 8 QCOM             3.57 1.31% 1.86%
 9 CSCO             3.28 -2% 3.45%
 10 V             3.22 2% 0.70%
Total           60.35 -4.19% 22.41%
Avg Div Yld 2.24%
Avg Ytd Return

AAPL, MSFT, VZ, IBM, T, ORCL, QCOM, and CSCO all sport P/E multiples below 20, while GOOG and V are the only real growth leaders among the top 10 stocks in XLK.  As a result, the XLK actually represents a basket of tech stocks that we would argue exhibits much less froth than the broader tech sector as a whole. Additionally, this list above exhibits some fairly defensive qualities, cheap valuations, strong balance sheets with tons of cash, reasonable dividend yield (on avg about 2.24%) and massive share buybacks.

If you are of the mindset that the largest sector of the S&P 500 (Tech at about 19%) will lead any further gains in the broad  market, then the XLK could be the way to express that view.  If AAPL and some of the other large components were to go up on the year, they could outperform if there was a rotation or a broadening out of the rally.  On the flip-side the defensive qualities could cause the etf to outperform on the way down if were to re-test the prior lows from earlier in the month.

I am not a huge fan of getting long much up here, but the markets continued resilience suggests that the pain trade could be higher.  SO I want to set up a trade that plays for continued consolidation in the near term, or a slow grind higher, with a possible breakout in late spring.  

From purely a technical standpoint, the etf’s ability to consolidate in and around the highs is fairly important, and bulls will want to see the XLK hold $36/$35.50 and the next sell off.

[caption id="attachment_36991" align="aligncenter" width="589"]XLK 6 month chart from Bloomberg XLK 6 month chart from Bloomberg[/caption]

So what’s the trade?  I could see some consolidation in the near term, maybe up or down a few % in the coming weeks. I want to own a longer dated XLK call*, but I want to help finance it by selling a shorter dated call, and continue to do this over the coming months.

TRADE: XLK ($36.19) Buy March 28th weekly / June 37 Call Calendar for .50

-Sell to open March 28th weekly 37 call at .12

-Buy to open June 37 call for .62

Break-Even on March 28th weekly Expiration:

-Profits are maximized at 37 on March28th weekly expiration. Slight moves above and below that strike are also profitable with big moves higher or lower putting the structure at risk of losses on expiration.

-Max risk is .50

Rationale:  As I said above, I want to consider this a bit of a “layaway trade” as I am not certain that this is the right entry but the idea of helping to finance the longer dated calls over a period of time is quite attractive.  As I get to the end of March I will look to roll the short calls and further reduce the cost of the June 37 calls that I own.

* for those ragin bulls who think we are off to the races I considered just buying the June 37 call and letting it ride, but I prefer a slightly more cautious approach.