New Trade – $XLU: Utility Playa

by Dan December 26, 2014 1:42 pm • Commentary

Earlier today, in an otherwise quite trading day, there was a large trade in the etf of the best performing sector in the S&P 500 that caught my eye.  When the XLU, the Utility Select SPDR etf  was at $48.50, there was an opening buyer of 37,000 March 47 puts paying 99 cents, committing almost $3.7 million in premium to the trade.  This trade breaks even at $36.01, down about 6.5% on March expiration.  Regular readers know we don’t place too much emphasis on unusual options activity, as what appears to be an outright bearish trade, could just as easily be a hedge against a long portfolio of utility stocks.

But there are a few things that I find interesting about this trade, in a sector that is trading at new all time highs, just like the broad market, but more than doubling the performance of the S&P (up 13%) in 2014, up 31%:


The outperformance of the XLU, is surprising, even given the recent drop in oil, when you consider the too five holdings (DUK, NEE, D, SO & EXC which make up about 38% of the weight) have an average dividend yield of about 3.35%. Not a whole heck of a lot higher than the 2% expected for the S&P 500 in 2014.  What’s more, the components of the XLU are not exactly cheap, looking at the five largest holdings vs the S&P 500 trading at about 14.5x  2015 expected earnings growth of about 10%.  On average the five previously listed Uts are trading at about 18.5x expected earnings growth of about 5.5%.

So what are you getting for that added yield, expensive low growth stocks with investor sentiment very high.

Technically, the chart is a work of art as it opened 2014 on the lows of the year and looks to be headed for a close at or very near the highs:

XLU 1yr chart from Bloomberg
XLU 1yr chart from Bloomberg

Despite the generally dovish view of the U.S. Fed, but without QE in place, one would suspect a gradual rise in rates in 2015, especially if the U.S. economy continues to demonstrate its relative strength to the rest of the globe.  I am just not sure how Utilities can continue this sort of out-performance in the new year despite the perceived benefit of lower input costs from the decline in crude oil.

Here is the thing for you options peeps out there. Implied volatility, the price of options is not exactly cheap on a historical basis, nearly 100% above the all time lows made in early 2013, and just a couple points off of the multi-year highs made in Oct:

XLU 3yr chart of 30 day at the money IV from Bloomberg
XLU 3yr chart of 30 day at the money IV from Bloomberg

Long premium directional plays will have to be well timed, as a consolidation in the etf would likely cause options premiums to be under pressure, making spreads mildly more attractive as opposed to outright purchases.

In light of this morning’s price action though it seems at least one large playa sees it the way we do, that there are few scenarios where Utilities should continue to outperform, and that options prices, while not exactly cheap offer a fairly healthy risk reward for those looking to make defined risk directional bets.

TRADE: XLU ($48.50) Buy to Open March 48 / 44 Put Spread for $1.00

-Buy to open 1 March 48 put for 1.35

-Sell to open 1 March 44 put at .35

Break-Even on March Expiration:

Profits: between 47 and 44 make up to 3.00, max gain of 3.00 below 44

Losses: between 47 and 48 lose up to 1.00, max loss of 1.00 above 48

Rationale:  The components of the XLU seem expensive relative to the broad market for the 1.5% added yield over the S&P500. While options premiums are elevated they seem reasonable relative to the potential for a re-tracement in the new year of a portion of the 11% move since its breakout in late October.  This trade structure targets on the low end the breakout level:

XLU 1yr chart from Bloomberg
XLU 1yr chart from Bloomberg

We would probably look to take off for a quick double, which makes selling the 44 put strike an attractive way to reduce our premium outlay in the event the etf takes some time to come our way.  This trade has a 3% break-even level to the downside.