High Technical Assistance – $XLK

by Dan April 22, 2016 2:57 pm • Commentary• Trade Ideas

Earlier today I offered some thoughts on Q1 earnings season (read here), but the quick take-away as we finish the second full week of results is that stocks that had low expectations and had not outperformed the broad market from the February lows have done ok (bank stocks), and the opposite for those where the stocks had come within striking distance of their prior highs (GOOGL, MSFT, KO, V & VZ to name a few).  The fairly dramatic weakness in GOOGL and MSFT (down 6% and 7% respectively) is notable when you consider that the two stocks combined have shed $60 billion in market cap today.

Trading single stocks into events like earnings is a fairly difficult way to make consistent money in the markets, even using options to define your risk. As regular readers know, you need to get a lot of things right to just break-even, first and foremost direction, magnitude of the move and timing.  We are huge advocates of overlying options strategies to existing investment holdings into earnings events as they can often be used to add yield, protect gains or add leverage.

Just as was the case last night, nearly $1 trillion in market cap in two stocks report Tuesday and Wednesday:

Apple (AAPL) reports Tuesday night after the close, the options market is implying about a 4.5% one day move, vs the 4 qtr average one day move of about 4%, but in line with the 10 year average. Put another way, the options market is suggesting that share of AAPL could be $28 billion higher or lower the day after results.

Facebook (FB) reports Wednesday night after the close, the options market is implying about a 7.5% one day move (about $24 billion in market cap in either direction), which is rich to its 4 qtr average of about 6.25%, but nearly half of the stock’s 15.5% one day gains following their blowout Q4 results in late January.

I want to look at the XLK, the Technology Select etf, where the top 10 holdings make up about 65% of the etf’s weight.  Of these 10, only AAPL, FB, T & CSCO have yet to report, with all but CSCO reporting next week:

From Bloomberg
From Bloomberg

If AAPL and FB were to disappoint I suspect large cap tech could spend the rest of the Spring retracing a bit of its recent move from the February lows.

A look at the one year chart of the XLK shows the etf’s recent rejection at the prior highs from late last year, with a clear target to its Jan/Feb double bottom back at $38:

XLK 1yr chart from Bloomberg
XLK 1yr chart from Bloomberg

Short dated options prices in the XLK have just come off of the 2016 lows, with 30 day at the money implied volatility (blue) at 15%, below the 1 year average of about 18%.  What is striking is that until very recently, and off the Feb lows, mega cap tech stocks were considered to be safe holdings, as 30 day at the money realized volatility (how much the stock was moving, white below) was at the lowest levels of the last year:

From Bloomberg
From Bloomberg

If AAPL, FB and T were to all disappoint next week, the way MSFT, GOOGL and VZ did this week, the XLK would very likely re-test its 200 day moving average near $42, causing a pick up in realized volatility, making current options prices even with today’s decline prove cheap.

So whats the trade?  

First things first I think if this market has taught us who like to short things anything, is that you don’t press shorts on a down day. With AAPL’s results not until Tuesday night and FB till Wednesday, the trade I am going to detail I hope to trade on a bounce in the XLK, and slap on just prior to AAPL’s results.

Trade Idea: XLK ($43.50) Buy Sept 43/ 39 Put Spread for $1
  • Buy to open 1 Sept 43 put for 1.75
  • Sell to open 1 Sept 39 put at 75 cents

Break-Even on Sept Expiration:

Profits: between 42 and 39 of up to 3, break-even at 42, down 3.5% with max gain of 3 below 39, or down 8%

Losses: up to 1 between 42 and 43 with max loss of 1 above 43, or 2.3% of the underlying stock price.

Rationale: This trade targets a fairly reasonable pullback in the sector after some notable failures at all time highs. By choosing Sept expiration we are allowing ourselves enough time for a correction to play out and therefore doesn’t just specifically target next weeks earnings in AAPL and FB, but will also incorporate Q2 results due in July. But since the index is down today on GOOGL and MSFT and other stocks down in sympathy that have yet to report I want to give it a chance to bounce a little into AAPL and FB earnings. So I’ll be looking to put this on at a slightly higher level on Monday or Tuesday.