The volatility in the Biotech sector over the last week (like the iShares Nasdaq Biotech Index (IBB) down 7% and at one point down 10% yesterday!) has raised some eyebrows as it marks one of the first bouts of equity volatility amidst a backdrop of extreme volatility among almost every other publicly traded risk asset, including commodities, currencies and U.S. Treasuries. I, like many market participants, have been confounded by the lack of equity vol given QE coming to an end and the potential for higher rates. Which is why keeping an eye on the slightest uptick in volatility in some of the most beloved equity sectors makes a lot of sense.
As for Biotech, a look at the valuations the four largest components of the $IBB – AMGN, BIIB, GILD and CELG (which make up about a third of the weight of the etf) – are not exactly expensive when you consider their expected growth. But its safe to say that my not be the case further down the market cap food-chain, like in the XBI (the S&P Biotech etf) which is far more evenly weighted among a much broader group of smaller market cap stocks which is far less palatable from a valuation perspective. The XBI displayed far greater volatility in the last week than did its larger cap brethren, the IBB. At one point in the last week the XBI was down 15% from the recent all time high made on March 20th, and is still down 10% (vs now 7% decline and at its worst 10% decline in IBB). This is an important comparison as it reflects the likelihood that if we are in fact going to get an equity correction it is likely to start in small caps, and then find its way into large caps.
Which brings me to the Russell 2000, and specifically the IWM. Many observed the long period of under-performance to the Nasdaq and the S&P in 2014 and took it as a potential harbinger of a broad market correction to come. Well, the IWM eventually broke out this year to new all time highs. But now it could threatening a failure:[caption id="attachment_52288" align="aligncenter" width="600"] IWM 1yr chart from Bloomberg[/caption]
If the IWM were to break $120 (which was the prior breakout level) and also the March low, then we could see a quick move back towards the 2015 low of $115.
I want to isolate that $115 level and play for a move back there in the coming weeks. Why in the coming weeks? Yesterday in the MorningWord (here) I highlighted the early weakness in the first few weeks of each new quarter over the last year, despite the S&P 500’s year end gain of 13%:
From April 4th to April 14th 2014 the SPX dropped nearly 4.5%
From July 3rd to Aug 7th 2014 the SPX dropped a little more than 4%
From Sept 30th to Oct 15th 2014 the SPX dropped about 7.5%
From Dec 31, 2014 to Feb 2nd 2015 the SPX dropped nearly 4%
And I also suspect we could see some weakness into earnings season as corporate earnings growth is crimped by the surging dollar. While stocks in the Russell 2000 tend to be less susceptible to dollar strength due to less overseas exposure they will likely be prone to volatility in domestic economic data like the weak durable goods data we got Wednesday.
Here is the trade:
Trade: IWM ($122.85) Buy to open May 120/115/110 Put Butterfly for .55
-Buy to open 1 May 120 put for 2.05
-Sell to open 2 May 115 puts at 1.00 each or 2.00 total
-Buy to open 1 May 110 put for .50
Break-Even on May expiration:
Profits: between 119.45 and 110.55 make up to 4.45, with max gain of 4.45 at 115
Losses: up to .55 between 110 and 110.55 & between 119.45 and 120, max loss of .55 below 110 and above 120
Rationale: This could be a set it and forget it type trade because of it’s nearly 10-1 payout potential. If the market does in fact see further weakness the target of 115 seems entirely possible and would be a nice win whether it happened next week or in the days before May expiration. But as with any fly the closer it happens towards expiration the better. But at .55 it’d be hard to mess this one up on any kind of sell-off.