Has the Risk-Off Flip Been Switched?

by Tyler Craig | September 26, 2012 9:26 am

The process of analyzing the financial markets can range from something as shallow as a cursory glance at the S&P 500 Index to something as in-depth as a comprehensive inspection of every single sector or industry. Some spectators are satisfied just knowing whether the broad market is in an uptrend or downtrend, while others want to dig deeper to unearth exactly which securities are driving the market higher or lower.

The healthiest bull markets are generally led by risk-on sectors such as consumer discretionary, technology and industrials. When optimism abounds, money tends to flow into these more aggressive sectors in an attempt to maximize returns. If commodities join the throng, basic materials and energy-related stocks may also climb aboard the bull train.

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On the other hand, when risk aversion rules the day, money tends to flow into a handful of risk-off sectors like consumer staples, utilities and health care. Companies residing in these sectors are less economically sensitive and are, therefore, perceived as less vulnerable to slowing growth.

Despite the fact that the Dow Industrials, Nasdaq and S&P 500 all remained firmly entrenched in uptrends, a look at sector performance for the past week reveals a somewhat disconcerting development. The three sectors boasting the best relative performance for the week are utilities, health care and consumer staples.

It appears the flip has been switched from risk-on to risk-off for the time being.

Now, to be fair, the market has been retreating over the past few trading session, so it’s not all that surprising that defensive sectors have held up the best. Moreover, one week worth of performance is arguably too small a window to draw meaningful conclusions from.

Nonetheless, this is a trend the bulls do not want to see persist. The most bullish scenario going forward would be for the current market dip to be bought post haste and for money to rotate back into the typical offensive sectors.

Of course, the market could also transition into some type of trading range for the coming month to digest the recent gains before heading higher.

One strategy particular well equipped to exploit a range-bound market is the iron condor. To enter the position, traders simultaneously sell a bull put spread and a bear call spread in the same expiration month.

For example, traders comfortable betting the SPDR S&P 500 ETF (NYSE:SPY[1]) will be contained within a range could sell the November 137-132 bull put spread along with the November 150-155 bear call spread for a total net credit of $1.10. If SPY remains between $150 and $137 by November expiration, both vertical spreads will expire worthless — allowing you to capture the entire $110 credit.

The max risk is limited to the distance between strike prices minus the credit, or $390.

As of this writing Tyler Craig had no positions on any securities mentioned here.

  1. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY

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