$XLB: 1st Attempt Had A Material Error – Timing

by Dan March 10, 2016 11:11 am • Commentary

On February 19th I detailed my bearish view on material stocks which had a massive bounce off of their recent lows (read here).  Some thoughts from my prior post:

In the near term I suspect we see a investor move out of the 2016 out-performance trades in sectors like basic materials as it appears to me that without any real fundamental improvement that the recent rip was nothing more than a short squeeze.

The XLB, the Materials Select etf is made up of a lot of chemical companies like Dow Chemical (DOW), Dupont (DD), Monsanto (MON), Lyondell (LYB), Praxair (PX) and Air Products (APD) which combined make up about 50% of the weight of the etf. These stocks got nailed in 2015 given their massive exposure to the strength of dollar, which ironically was offsetting the benefit of lower oil costs, which is a massive input to most of these companies.  Lastly there are also mining and metals stocks like Alcoa (AA), Newmont (NEM), Nuecor (NUE) and Freeport (FCX), all of which have had massive gains of late from recent lows.

It’s my view that if the broad market moves lower, we will see correlations go back towards one, and these stocks could see a sharp move lower as those who had a good trade look to lock in profits, and shorts take another crack.

Nothing has really changed since then, except for the fact that the XLB has rallied about 6.5% making my trade nearly a total loser.  To refresh, here was my trade from Feb 19th:

XLB ($40.75) Buy March 40 Put for 90 cents

The biggest error of this trade, aside from being wrong on entry, was not cutting my losses. Partly because I was wrong so quickly. We usually like to use a 50% premium stop on long premium directional trades.

But I am nothing if not persistent.  The etf is now consolidating just below long term resistance and its 200 day moving average (yellow line) now unchanged on the year:

XLB 2yr chart from Bloomberg
XLB 2yr chart from Bloomberg

The etf remains in a downtrend, and the 20% rally over the last month feels like its run out of steam.

So What’s the Trade?

*XLB (43.45) Buy the June 43/38 put spread for 1.30
  • Buy 1 June 43 put for 1.93
  • Sell 1 June 38 put at .63

Breakevens on June Expiration:

Losses: of up to 1.30 with stock above $41.70 with total loss of 1.30 above $43

Profits: of up to 3.70 below $41.70 with max gain at or below $38

Rationale – This trade has good risk reward and looks far enough out for time to be right on this rally from the lows already being tired. We don;t have to worry about decay much to start so it’s merely deltas and a directional call.