New Trade – $XLU: Utility Playa

by Dan September 12, 2014 1:43 pm • Commentary

Earlier, Enis highlighted the sharp move lower in the IYR, the iShares Real Estate etf. It is down about 4% on the week and 2% today alone.  Obviously, the move in rates this week is anticipating the FOMC meeting next week, which is likely to be the last press conference before concluding the longstanding bond buying program.

It’s notable how quickly market participants have changed their positioning despite the weak jobs data from August (reported last Friday). The move in the 10 yr Treasury yield this week (as illustrated by the sharp decline in the TLT chart below) shows that traders are clearly expecting high rates sooner than they did just 2 weeks ago:

TLT 10 day chart from Bloomberg
TLT 10 day chart from Bloomberg

What’s also interesting to note is the view towards higher yields came at massive long term technical resistance, just below $120 (red line below on 2yr TLT chart):

TLT 2yr chart from Bloomberg
TLT 2yr chart from Bloomberg

In the near term, I suspect that $110 (green line) level could serve as important technical support as it was the low in 2012, and was an important part of the bottom put in last year.  The $110 level also corresponds with the etf’s 200 day moving average (yellow line and circled).

Just like IYR, another high yielding sector etf, XLU, the SPYDR Utilities etf, was hard hit in the 2013 “Taper Tantrum”, and once again looks vulnerable to a decline if rates continue to rise quickly coming months as the Fed ends QE.   The two year chart of XLU below shows the importance in the near term of the $42 level (in red) and the logical support at $40 (in green the low from August):

XLU 2 yr chart from Bloomberg
XLU 2 yr chart from Bloomberg

And here is the kicker for those looking to pick on some of the high yield sectors – despite the recent price decline, and vol spike, vol is still relatively cheap on an absolute basis if in fact we were to get a continuation of the weakness:

XLU 2 yr chart of 30 day at the money IV from Bloomberg
XLU 2 yr chart of 30 day at the money IV from Bloomberg

Given that implied volatility is still in the mid-teens, we prefer going out a few months in expiration to give us more time to potentially capture a move lower in XLU.  Based on the recent volatility in Treasuries, the utility sector is likely to get more volatile in the coming weeks as well.

XLU ($42.35) Bought to Open Oct 42/40 Put Spread for .60

-Bought 1 Oct 42 put for .80

-Sold 1 Oct 40 put at .20

Break-Even on Oct Expiration:

Profits: btwn 41.40 and 40 make up to 1.40, max gain of 1.40 below 40

Losses: up to .60 btwn 41.40 and 42, with max loss of .60 above 42

Rationale:  This trade targets the early August low near $40 in XLU.