Trade Idea – $XLU: Utility Playa

by Dan November 9, 2015 2:10 pm • Commentary

On the heels of Friday’s stronger than expected October jobs data, Utility stocks were the hardest hit sector in the market, with the Utilities select etf, the XLU closing down nearly 4%.  For the second time in two months, the XLU is very near testing the uptrend that has been in place since its financial crisis lows:

XLU 7 year chart from Bloomberg
XLU 7 year chart from Bloomberg

The six month chart of the XLU has been a bit manic. Keeping in mind that investors flock to a high yielding sector like Utilities when expectations that interest rates will go lower (the top 5 holdings in the XLU make up nearly 40% of its weight and have an average yield of 4%) and as was the case on Friday sell them when they fear a period of higher rates:

XLU 6 month chart from Bloomberg
XLU 6 month chart from Bloomberg

But the etf has found considerable support between $42 and $41 and resistance at $45. Today’s price action across risk assets is fairly interesting, especially when you considered the equity market’s muted reaction as a whole on Friday.  Bond prices continue lower today, with yields up, and the XLU is flat, finding a little support just above $42.  One thought here is that if the Fed does raise at their December 16th meeting, they may continue to issue a dovish tone.  But the recent strength of the dollar suggests that the easing by almost every other central bank in the world could keep our yields weak, with little downward pressure on the dollar.  In this scenario, investors could once again be attracted to a sector like Utilities that has little cyclical pressure, no overseas/dollar exposure, sports a healthy yield, and is 15% from its 52 week highs made earlier in the year, and testing key long term support.

Utility stocks could set up as a contrarian buy, and if for any chance the FOMC does not raise rates in Dec, or consensus views it as one and done, the XLU could find itself right back in the mid $40s.

Short dated options prices in the XLU have just come off of 52 week lows which is interesting when you consider very few other S&P 500 sectors saw options prices make new 52 week lows after the massive vol spike in August:

XLU 1yr chart of 30 day at the money Implied Vol from Bloomberg
XLU 1yr chart of 30 day at the money Implied Vol from Bloomberg

I suspect short dated options prices are not gonna go much lower between now and the Dec 16th meeting, making those looking to express directional views in the sector more inclined to do so with long premium strategies.

In the near term we might see lower lows, possibly as low as $41, but I expect it to hold its trend at $41.25. One trade I like is a call calendar, selling short dated out of the money calls to help finance the purchase of longer dated calls playing for a bounce into the Dec FOMC meeting after a sharp decline.  

*Trade: XLU ($42.25) Buy Nov / Jan 43 call calendar for 50 cents

-Sell to open 1 Nov 43 call at 20 cents

-Buy to open 1 Jan 43 call for 70 cents

Break-Even on Nov Expiration:

-Max gain at $43, max risk of 50 cents with a large move above or below the 43 strike.

Rationale:  The XLU could be range bound in the well identified support range, but with looming catalysts, and what appears to be growing consensus on what’s going to happen, cotnrarian defined risk trades may soon start to look attractive.  The idea here is that the XLU consolidates for the next couple weeks, closes below $43, having the short Nov call expire worthless and then either sell a higher strike call in Dec making a diagonal calendar, or a higher strike call in Jan making a vertical call spread and further reducing the premium at risk.

One last point, this trade is predicated on the XLU holding the uptrend, if it were to break below $40 there is little support until $38ish, which helps makes the case for defined risk. If that breakdown were to occur we’d keep a stop below $40.