New Trade – $DIA: Blast From the Past

by Dan October 21, 2014 1:12 pm • Commentary

Regular readers of the site know that we don’t generally refer to the U.S. equity market in terms of the Dow Jones Industrial Average (DJIA).  The index of 30 stocks (largely not industrials) is price weighted, vs the S&P 500 which is weighted by the market caps of its components.  The DJIA generally does not show the sort of breadth that investors should expect for an economy that has grown exponentially in size and scope since the index’s conception in the 1800’s.

So while we don’t view the DJIA as an important market barometer, we do find the price action of the collection of 30 stocks interesting on a relative basis to broader equity indices, and from time to time use it as a trading tool.

This is a fairly obvious conclusion due to weightings and the sheer volume of components, but large moves by a small number of stocks can have a large impact on the DJIA, while large moves in an index by a few names in the SPX will have a more muted affect on the index.

This week the earnings disasters du jour have come in the DJIA, with shares of IBM, KO & MCD all declining despite market strength.  As a result, the Dow has lagged behind the SPX and Nasdaq 100 as the only large cap index still below its 200 day moving average. But despite the momentum lag, and likely the result of the huge move of IBM yesterday and KO today, it’s also interesting to note  that in the context of the market sell off of the last few weeks, the DJIA had the shallowest peak to trough drawdown from the recent highs at about 8.6% vs the SPX at 9.8%, the Russell 2000 (IWM) at 14.4% and the Nasdaq 100 (QQQ) at 10.2%.

The one year chart of the DJIA chart shows the index at an important technical level, and right at its 200 day moving average (yellow):

DJIA 1yr chart from Bloomberg
DJIA 1yr chart from Bloomberg

From a recent volatility standpoint, the DIA (the etf on the DJIA) has had elevated levels of realized vol (how much the index is actually moving) while the implied vol (the price of options) remains slightly below realized.  If realized vol was to stay elevated and U.S. equities were to re-test last week lows, implied vol could prove to be cheap:

DIA 1yr chart of 30 day at the money iv (blue) vs realized (white) from Bloomberg
DIA 1yr chart of 30 day at the money iv (blue) vs realized (white) from Bloomberg

It is my sense that the DJIA’s relative under-performance (flat on the year vs the SPX up 4.6% and the NDX up 5.2%) was in large part due to the weakness in earnings of some of its components.  That weakness comes from no shortage of reasons but the biggest may be legacy businesses getting hit by competition, which is what we saw this week from IBM and MCD.  The most recent addition to the list is a stronger dollar.  Many of the multinationals in the DJIA index get more than 50% of their sales from overseas.

With the index at resistance and large cap multinationals (ex-AAPL) earnings discouraging, we are going to place the following defined risk bearish trade in the DIA:

TRADE: DIA ($165.11) Buy Dec 165 / 155 Put Spread for 2.60

-Buy 1 Dec 165 Put for 4.10

-Sell 1 Dec 155 Put at 1.50

Break-Even on Dec Expiration:

Profits:  between 162.40 and 155 make up to 7.40 with max gain of 7.60 at 1.55 or below

Losses: between 162.40 and 165 lose up to 2.60, with max loss of 2.60

Rationale:  This trade is a good risk/reward way to play for further weakness in DIA over the next two months.  The structure will hold its value better than a shorter-term trade in November expiry since its time decay is lower, and it only needs a 2% move lower to have intrinsic value equal to our cost (of around $2.60).  We would likely look to take the trade off on a visit back to last week’s lows, where it would be around a double.