New Trade – $XHB: Arrested Development

by Dan March 6, 2015 1:37 pm • Commentary

Regular readers know I try to steer clear of forming deep rooted macro views on the market. But for some reason at the end of last year into the start of 2015 (like others) I started to feel that the spike in bond proxies like Utilities and the parabolic move in Treasuries was unsustainable in the face of what would eventually have to be an increasingly hawkish Fed given the pace of our economic recovery. To be fair this was kind of a consensus view, but the real trick was finding the best way to play from a risk reward perspective.

Back on Dec 26th I had the following to say about the XLU (Utilities select etf) when it was $48.50 (New Trade – $XLU: Utility Playa):

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.

Back on Jan 13th I had the following to say about the near term demand for U.S. Treasuries when the TLT (iShares 20 yr bond etf) was $133.50 (TLT: No Mr. Bond, I Expect You To Die):

It is our sense that the U.S. Treasury rally is getting long in the tooth, despite the growing uncertainty in global growth, the surge in the dollar, the crash in industrial commodities and the erratic behavior by a growing number of central banks.  It’s our view that we could be near a period of moderation of Treasury bond demand as we get closer to the ECB’s much anticipated January 22nd meeting and likely decision to get into the QE game.  And I’ll take it a step further, with the next FOMC meeting on Jan 28th, I doubt there will be too many surprises from last weeks minutes of the December meeting, but following meeting on March 18th could be the one where the Fed strikes a more hawkish tone If in the meantime we were to get a continuation of better jobs data (with some wage growth) here in the U.S., improving manufacturing data, stabilization of  commodity prices and the slightest bit of inflation, the talk prior to the March meeting will once again turn to how soon the Fed can raise.

So here we are on the day of the Feb Jobs data and it has all played out.  Utility stocks have almost round tripped their epic breakout in October, and U.S. Treasuries have declined 10% from last month multi-year highs and round-tripped their entire year to date move.

So if you think there is more to go, but these two instruments are bad presses on the short side after such short term declines, then what’s next??

Probably housing. I know some of the recent data has been very good, with household formation spiking in February to multi-year highs and recent positive earnings and commentary from Toll Brothers (TOL), but that could be the last push prior to a period of moderation in the face of higher mortgage rates off of sustained historically low levels.

I am going to keep this simple. The XHB (Homebuilder etf) also has tons of retail related exposure and had a 35% rally from the multi year lows in mid October to the recent highs:

XHB 2yr chart from Bloomberg
XHB 2yr chart from Bloomberg

Options prices look fairly reasonable with 30 day at the money implied vol having just picked up a tad off of the 2015 lows:

XHB 30 day at the money IV from Bloomberg
XHB 30 day at the money IV from Bloomberg

So here’s the trade:

TRADE: XHB ($35.50) Buy the April 35 /32 put spread for .65

-Buy 1 April 35 put for .80

-Sell 1 April 32 put at .15

Break-Even on April Expiration:

Profits: between 34.35 and 32 of up to 2.35, max gain of 2.35 below 32

Losses: between 34.35 and 35 lose up to .65, max loss of .65 above 35

Rationale: Vol is cheap, the chart looks like it could be rolling over and it makes sense from a macro perspective. There could be a last minute scramble in housing in the face of rates about to rise and if that’s the case April may not be enough time for it all to play out. But I feel the space is suddenly vulnerable and traders may start to try to get ahead of it.