Name That Trade – $DIA In the Rough?

by Dan April 10, 2015 1:56 pm • Commentary

A fortnight ago we considered portfolio protection using the SPY (read here).  Since that time the S&P 500 is up about 2%, and once again threatening to make a new all time high, now just 1% below the February highs.  Prior to that post I highlighted (here) the downward volatility we have seen in the first few weeks of new quarters over the last year, which also corresponded with the start of earnings season:

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%

SPX 1yr chart from Bloomberg

You probably get the point.  Could we be on the cusp of a repeat? It doesn’t feel that way, especially when you consider this week’s equity rally in the face of Friday’s weak March jobs data. I remain perplexed by the fact that investors here in the U.S. cheer weak economic data with the hope that it means a push out of interest rates hikes.  But that’s neither here nor there. If the Fed doesn’t nail the landing, and we get some sort of unexpected results from the ECB’s QE, and those of China and Japan, this will all come home to roost. And in some ways it already is, the Fed would love to talk the dollar down a bit, but it is nearly impossible for it to go down when almost every other central bank the world over is squarely focused on debasing their own currencies.

Which leads me to the Dow Jones Industrial Average, a very imperfect index as it is calculated on an equal weight basis, vs the S&P 500 which is weighted average by market cap, largely the reason why the index has fallen into deep obscurity among institutional investors.  But this imperfection can present trading opportunities, where a few stocks can have a dramatic impact on the index. Looking at the performance of Dow Components, 18 are up and 12 are down on the year, but the index is only up 1% year to date.  Six stocks are skewing the performance, AAPL up 15% ytd, BA up 19%, DIS up 13.5%, HD up 10%, PFE up 13.5% and UNH up 17.5%, while it seems like the rest of the index is in dollar strength hell given their revenue exposure outside the U.S.

While sentiment into Q1 earnings may be low, I suspect a weak dollar is a long time coming, and whether stock’s take weak Q2 guidance in stride, it could still make sense to seek what appears to be cheap protection in the event that history repeats itself.  

Potential Large Cap Multi-National Portfolio Protection:

DIA ($180.50) Buy May 180/170 Put Spread for about $2

-Buy 1 May 180 put for 2.65

-Sell 1 May 170 put at .65

Break-Even on May Expiration:

Profits: between 178 and 170 make up to 8 with max gain of 8 at 170 or lower.

Losses: between 178 and 180 lose up to 2, with max loss of 2 above 180, or about 1.2% of the etf price.

Rationale:  If history does repeat itself I suspect that large U.S. multinationals will be at the center of any sell off, the concentration of this group in the Dow 30, coupled with any disasters from some of the leaders could cause the Dow to demonstrate under-performance.

The choice of strikes is pretty simple, 18,000 on the Dow seems to be a level, and the index has made a series of lower highs since early March, a break below 18,000 could cause a retest of the Feb lows of 17,000.  I suspect the Index finds some support at those levels.

[caption id="attachment_52683" align="aligncenter" width="600"]Dow Jones Industrial Average 1yr chart from Bloomberg Dow Jones Industrial Average 1yr chart from Bloomberg[/caption]

We are not putting this trade on, we are kind of covered on bearish index plays QQQ (here) and IWM (here), but we thought this was an attractive idea for those who find U.S. multinationals vulnerable over the next month.