Trade Idea – $XLU: Utility Player

by Dan December 11, 2015 3:22 pm • Commentary

As we near the Federal Reserve’s last FOMC meeting of the year next Wednesday, the Fed Fund futures are implying about a 72% change that the committee will vote to raise interest rates for the first time since June 2006, ending seven years of ZIRP. It’s important to note that earlier this week, prior to crude oil’s 11% 5 day slide, the SPX’s 3.5% decline, the yield on the 10 year treasury making new one month lows and high yield debt markets making multi-year lows, the probability of a raise was at 80%:

from Bloomberg
from Bloomberg

It’s been my view for some time that the Fed is dammed if they do, damned if they don’t on an impending rate increase, which is why they might as well get on with it and see where the chips fall. Given the recent volatility in risk asset prices it makes perfect sense that a rate increase would be matched with language that would suggest that the central bank will remain very accomadative and ready to act if in fact the U.S. economy were to weaken due to external factors.

Soft U.S. Treasuries yields in front of the expected rate increase this week suggest to me that that rates aren’t going anywhere (for now), and that investors may revisit high yielding sectors/stocks in the U.S. that don’t have exposure to a strengthening of the dollar given their domestic exposure. Utility stocks fit this bill, as the top 5 holdings in the XLU (etf that tracks the sector) make up nearly 40% of its weight and have an average yield of 4.2%

From purely a technical standpoint, the XLU has held its uptrend from its 2009 lows like a boss, just now re-testing, but at very important technical support just below $42:

XLU 7yr chart from Bloomberg
XLU 7yr chart from Bloomberg

The two year chart below shows what I believe to be a sort of risk 1 make 2 scenario, with near term downside risk down to about $40, and upside potential up to about $46:

XLU 2 yr chart from Bloomberg
XLU 2 yr chart from Bloomberg

Short dated options prices, while elevated alongside heightend volatility in the last couple weeks across all risk assets, is still well below the August spike and that of Q1:

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

Options prices are cheap enough for those looking to make directional bets to purchase them outright, and look to spread on a move in desired direction to reduce premium at risk.

So What’s the Trade?

I’m already involved in XLU from a bit higher and therefore want to roll my exposure to be closer to the money. This is what I will end up owning and is also the trade that I would do now even without a previous position:

XLU ($41.80) Buy to Open the February 42 call for 1.00

Break-Even on February Expiration:

Profits:  above 43, up about 2.5%

Losses: of up to 1 between 43 and 42, with max loss of 1 below 42

BUT, with my existing position I need to roll into the Feb near the money call (that also gains another month in time) Here’s how that works. Back on Nov 20th we rolled a bullish position (read here) I am now going to roll the out month call of the calendar to that February strike:

  • Sell to Close XLU ($41.80) Jan 43 call at .30
  • Buy to Open the Feb 42 call for 1.00
New position: Long the XLU Dec 44/ Feb 42 call calendar for 1.20

The 1.20 cost reflects the 20c that the current position is down. But any moves higher from here and owning the Feb 42 will put us in a much better spot than sitting on the January 43 which is farther out of the money with less time. The December short call will likely expire worthless next week at which point we’ll look to roll the short call out, possibly to a vertical spread. This roll gives us more time and more deltas for a move higher.

Rationale – If the U.S. dollar were to make up some its lost ground of late investors could once again be attracted to a sector like Utilities which 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.