Back in November we considered the sector rotations happening in the stock market into and out of the election results. In particular we looked at healthcare stocks, which had sold off fairly dramatically into the election on the presumption of a Democratic sweep. It was our view into the election no matter what the outcome, the sector would bounce. They did see that bounce immediately afterwards, but quickly faded. On December 2nd we detailed a bullish trade idea in XLV, the healthcare sector etf. Here was the trade idea and rationale at the time:
But as we head into year end, following the Fed meeting we could see some sideways trading the closer we get the Christmas holiday, which makes long premium directional strategies unattractive.
So what’s the trade?
If you are inclined to play for bounce in the XLV over the next month and half it makes sense to consider strategies with minimal premium outlay. Zero cost risk reversals offer a good risk reward defining a range where you would get long on the upside, allowing room for error on the long entry:
Trade: XLV ($68.50) Buy Jan 66/70 Risk Reversal for a 5 cent credit
- sell to open 1 Jan 66 put at 80 cents
- buy to open 1 Jan 70 call for 75 cents
Rationale: This trade idea plays for a bounce in XLV where above 70 it is like being long the etf on Jan expiration. And below 66 it is like being long the stock on Jan expiration. 66 is the breakdown level and would be a place many would take a shot or place a GTC order. 70 is where there is some resistance and if the etf broke above that it could run a little. Anything in between 66 and 70 is like a free look.
That scenario we laid out played out pretty true to form as the etf went sideways into year end and has now caught a bid in the New Year. With XLV at $70.70, the Jan 70 calls are now in the money, and the risk reversal is worth 1.05. For those that are satisfied with those gains, the trade can simply be closed for a nice profit of 1.10. (the original trade idea was .05 credit).
But for those that would like to ride the momentum an adjustment here makes sense. The Jan 66 puts should be closed here as they are just .05. The Jan 72 calls can then be sold at .23, creating a 2 dollar wide call spread for a credit. The max gain possible into Jan expiration is then $2 plus the credit for Jan 72 call sale:
New Position: Long the XLV (70.70) Jan 70/72 call spread for a .23 credit (currently worth .90)
Rationale – The worst thing that could happen is for XLV to fail and close January expiration below 70, resulting in a .23 profit on the trade. The best case scenario is a close at or above 72 on Jan expiration, resulting in a 2.23 profit. Anything in between 70 and 72 on Jan expiration equals profits of the amount above 70, plus the .23 in booked profits.