This past year was an incredibly bull-friendly one in the equity markets. Even scary events managed to generate rallies.
Two sectors that stood out as overachievers were the financials and transports. Retail also had its moments, though we’re starting to see cracks.
Today, I want to concentrate on all three sectors, as all three are providing excellent trading opportunities heading into the new year. And we’ll use the following exchange-traded funds to trade them:
- Financials: Financial Select Sector SPDR Fund (NYSEARCA:XLF)
- Transports: iShares Dow Jones Transport. Avg. (ETF) (NYSEARCA:IYT)
- Retail: SPDR S&P Retail (ETF) (NYSEARCA:XRT)
For the past 20 days, rallies in the XLF, IYT and XRT have visibly eased. All three struggle to set fresh highs. Normally, this alone wouldn’t be a reason to short, but in light of how hard we’ve rallied since the election, this is worth the chance.
Let’s use the options markets so we take on very little out-of-pocket risk. We’ll also use slightly longer time frames (February or later) so we can abandon these trades if they go against us in early 2017.
Here are three trades I like heading into 2017, followed by my “bank trade” to lessen the out-of-pocket expense.
Trades to Rain on 2017’s Parade: Short the XLF
Click to Enlarge Fundamentally, the financial sector has not changed much this year. The uber-exuberance stems from the hopes of a Trump presidency removing red tape so banks can rebuild their business models.
In addition, the sharp spike in rates added fuel to the Financial Select Sector SPDR Fund (NYSEARCA:XLF) fire. Traders believe higher rates will translate into higher profits for banks.
My trade is an argument against the XLF components. I don’t argue with bank valuations; except for a few like Wells Fargo & Co (NYSE:WFC), they all are well-managed and well-capitalized companies.
My issue is that we got here too quickly and too steeply.
Technically, XLF’s chart looks like a goose-neck that needs another set of friendly headlines to maintain the meteoric rise. Otherwise, it’s vulnerable to gravity. A partial retracement would be normal.
The trade: Buy the XLF Feb $24/$23 bear put spread for 45 cents per contract. This is my maximum risk. To win, I need XLF to fall below my spread before expiration. I set the trade near the money so I only need to guess direction.
Trades to Rain on 2017’s Parade: Short the IYT
Click to Enlarge Similarly to the financials, the iShares Dow Jones Transport. Avg. (ETF) (NYSEARCA:IYT) spiked 17% in 24 bars in November.
Here again, I’m not so much dissing the sector’s valuation, but rather the manner in which we got to new highs. Wall Street priced in the full effect of Donald Trump’s promises in just a few days.
From here, I believe we will start chipping away at some of those promises.
The trade: Buy the IYT Feb $162/$161 bear put spread for 30 cents per contract. I can gain about 60 cents per contract if IYT falls below my spread.
Trades to Rain on 2017’s Parade: Short the XRT
Click to Enlarge Unlike for the XLF or IYT, I do have issues with retailers’ valuations. I have little faith that they have solved the riddle that is Amazon.com, Inc. (NASDAQ:AMZN).
The consensus is that brick-and-mortar retailers have shifted enough sales to online venues to lessen Amazon’s shellacking. I’m not convinced of this. And even if they did, I don’t think they’re prepared to see the real effects on their P&L’s.
The only hiccup here is that Netflix, Inc. (NASDAQ:NFLX) is part of the SPDR S&P Retail (ETF) (NYSEARCA:XRT). So I will need the help of a general market swoon to also tip NFLX lower, or else it could provide some prop effect.
The trade: Buy the XRT Feb $44/$43 bear put spread for 30 cents. You stand to gain 70 cents per contract.
And now, for the “bank trade.”
Trades to Rain on 2017’s Parade: Short the Small Caps (Bank Trade)
I usually like to lighten the out-of-pocket expense by selling risk. In this case, I won’t be balancing my trades, but rather simply bringing in funds to potentially finance the short trades.
I also won’t deploy the next trade immediately. Instead, I want to see how the next few candles go after setting the debit put trades. If and when I do deploy, it will make the whole setup one-sided, so I need to exercise discipline.
Collectively, the aforementioned three sectors are a large portion of the small caps. So it’s no surprise that the Russell 2000 and iShares Russell 2000 Index (ETF) (NYSEARCA:IWM) also rallied to new all time high in a ferocious manner.
The trade: To finance the purchase of my short XLF, IYT and XRT trades, I will sell a credit call spread in RUT. It will be for March expiration, with a 9% buffer from current price. Right now, that would look like a Mar 1490/1500 credit call spread to collect $1 to open. It would have an 80% theoretical chance of success and a 10% yield if successful. But again, I plan to do this later, so the strikes may differ down the road.
Shorting the Russell 2000 is hazardous but can be done — with caution.
We are not required to hold any options trades through expiration. We can close any of them at any time for partial gains or losses.
Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities. You can follow him on Twitter at @racernic and stocktwits at @racernic.
