XLY: At Your Discretionaries

by Dan January 6, 2016 1:50 pm • Commentary• Trade Ideas

To state the obvious, positive returns in U.S. equity markets were hard to come by unless you were invested in a couple dozen large cap growth stocks. And from a trading perspective it was a fool’s errand trying to short consumer discretionary names like Amazon (AMZN), Home Depot (HD) or Nike (NKE). But there were some obvious cases like Comcast (CMCSA) & Disney (DIS), prior market leaders that lost a little bit of the magic and limped into year end (despite closing up on the year they were down substantially from their highs).

Now we have a fairly sharp sell off to start the year in many of last year’s big winners. That should not come as a huge surprise as investors were waiting for the turn of the calendar to book some gains and avoid taxes in 2015, but much like 2000 and 2008, waning upward momentum from market leaders can mark the top of a bull run.

Which leads me to the Consumer Discretionary etf, the XLY, whose top 10 holdings (which include the 5 listed above) make up 40% of the weight:

from Bloomberg
from Bloomberg

The XLY in 2015 massively outperformed the S&P 500 (SPX), closing up a bit more than 8% vs the SPX which closed flat. That was largely due to the more than 100% gains in stocks like AMZN & NFLX, but also from a few retailers like HD, MCD, SBUX & NKE.

The ten year chart below of the XLY clearly shows the etf’s expanding distance from the uptrend that has been in place since the 2009 lows, yielding gains at the recent highs that doubled that of the SPX:

XLY 10 year chart from Bloomberg
XLY 10 year chart from Bloomberg

As one would expect, short dated options prices in the XLY are far cheaper than many of its high beta components, with short dated implied volatility at about 20%, well above its one year average of about 16%, but well below the highs reached in late August at nearly 34%:

XLY 1yr chart of 30 day at the money implied volatility from Bloomberg
XLY 1yr chart of 30 day at the money implied volatility from Bloomberg

If you are of the belief that stocks like AMZN, the largest component of the XLY at nearly 11%, could see a meaningful pullback in 2016, and drag down the XLY, but hesitant to make long premium directional bets in some of the etf’s components, then it could make sense to express a somewhat modified bearish view in the XLY.  In doing so it makes sense to sell short dated options to help finance the purchase of longer dated ones.

I like the idea of playing for a break back towards the trend line, but I suspect it will not happen in one fell swoop, it will take some time for prior market leaders like break-down, as was the case with Apple (AAPL) and DIS in the second half of 2015.

So what’s the trade?  

*XLY ($76) Buy Jan/ Feb 74 put calendar for$1

-Sold to open 1 Jan 74 put at .40

-Bought to open 1 Feb 74 put for 1.40

Breakeven on Jan expiration: profits if stock is at or near $74 on Jan expiration. Losses if stock is substantially higher or lower that $74.

Rationale – If stock is within striking distance of the strikeon Jan expiration we would look to roll to a vertical spread in February that catches alot of the etf components’ earnings.