After 7-Week Decline, XLU Trying To Stabilize – Options Offer Decent Risk/Reward

posted in: Derivatives, Equities, Technicals | 0

A trade with a neutral to bullish bias may be brewing in utilities.

Since peaking at $57.23 on November 15 last year, XLU (SPDR utilities sector ETF) came under severe pressure – down 10.8 percent through last Friday’s low of $51.07.

Support at $51 goes back to June 2016 (chart below), and seems to be holding.

Needless to say, the ETF ($51.81) remains oversold, and has tons of room for unwinding in the right circumstances.  It is trying to stabilize, and needs time.  As long as $51 is not violated, risk-reward odds favor the bulls.

There is short-term resistance at $52 and change, with the 10-day moving average at $52.07.  The 200-day lies at $53.56.

As things stand, a short put with a view to going long, if the need be, near the afore-mentioned support probably has merit.

Top five holdings of XLU are NextEra Energy (NEE), Duke Energy (DUK), Dominion Energy (D), Southern Company (SO), and Exelon Corp (EXC).  They respectively have weightings of 11 percent, 8.1 percent, 7.6 percent, 7.2 percent, and 5.6 percent.  They will report 4Q17 results in late January to early February.

January 26th options expire before that.

Hypothetically, slightly-in-the-money 52 put brings in $0.68.  Should XLU close above $52 by expiration, the credit is kept.  If instead the short put ends up in the money, that essentially ensures going long at $51.32 – just above last week’s low.

An additional bull put spread can further reduce the effective cost.

A 52/51 credit spread brings in another $0.38 – short 52 for $0.68 and long 51 for $0.30.

Overall, this nets $1.06, effectively reducing the cost to $50.94, should the naked short put be assigned and the underlying closes between 52 and 51.

The dynamics change, however, if XLU closes under $51 by expiration.  In this scenario, the bull put spread loses $0.62.  And with the $0.68 in premium from the naked short put, the whole exercise still earns a credit, but merely $0.06.  The position ends up going long the underlying at $51.94.

The best outcome hence is either XLU rallies past 52 or closes between 52 and 51.  The former earns a credit of $1.06 and the latter ensures going long at $50.94.

Thanks for reading!