Bulls were “Yellen” to a certain point in Wednesday’s session. But for investors willing to exploit potentially pricey valuations on the cheap; the new “easy money” could be a simple and effective bearish bet using the Select Sector Financial Slct Str SPDR Fd (NYSEARCA:XLF) put options.
Some rather direct Fed-speak from Federal Reserve Chief Janet Yellen noting “equity market valuations at this point generally are quite high” at an event sponsored by the Institute for New Economic Thinking appears to have helped XLF bulls gnaw on themselves Wednesday.
Is Wednesday’s casual conversation a prelude to the Fed implementing a sooner-than-expected teaser hike in June rather than September or December?
Regardless, when that day does arise, it should be a godsend for bulls in XLF if we’re to believe some Tuesday “rate vacuum” talk on CNBC.
XLF Weekly Chart
What could possibly go wrong with the analysts’ rational on CNBC? Rather than thinking linearly and optimistically about interest rates, I’d rather look linearly at the XLF chart and be prepared for more pragmatic and bearish headwinds … as well as the “we didn’t see that coming!”-type risks that always take markets, too fixated on one factor, by surprise.
Looking at the XLF weekly view and adhering to the K.I.S.S. methodology, the financial sector ETF has developed a triangular pattern since last fall. The mostly symmetrical shape lends itself to either an upside breakout or a breakdown and lower prices. However, a slightly more introspective but still simple observation favoring the bears are the pattern’s successive breaks of the prior uptrend line.
XLF Volatility
To complement our keeping it simple theme, volatility readings in XLF are also quite cheap overall and supportive of an outright long put purchase.
Implieds (blue line) for XLF or what you pay to own either a call or put and underlying stock volatility (brown) are in the lower half of the last three years range. That’s attractive as it suggests little downside risk regarding long volatility exposure.
As can also be seen, volatility levels in XLF are a far cry from 2011’s mini-crisis in confidence by investors and not to mention the even crazier, panicked premiums that occurred during the worst of the financial crisis.
Truthfully, I’d rather not go back down a road towards a credit crisis and revisit that type of over-the-top price volatility and uncertainty. At the same time, I do grow weary of financial muggings when the Street promotes, after a historic six-year run, why XLF or constituents such as Citigroup Inc (NYSE:C) or Bank of America Corp (NYSE:BAC) must go higher from here.
XLF Long Put Strategy
As for a bearish play in XLF, in checking the board I like making use of some time. As we’ve just begun the seasonally, but not always weak worst six months, the slightly out-of-money Sep $23 put for 50 cents, give or take a penny or two, is an effective way to prepare for history to potentially repeat itself.
What an investor gets for the September put is a contract that makes money should the XLF head lower. In fact, if XLF simply retests its February lows and the Sep $23 put is at the money, the trader can anticipate a 50% to 100% return and perhaps slightly more, depending on implieds getting bid up in the process.
By using September and 135 days remaining to expiration, there’s also very little time decay pressuring the XLF put. Time will tell, of course, if this turns out to be a new sort of “easy money” position.
If not and as to not get stuck on the wrong side of what a rate hike means in XLF or some other bullish catalyst for that matter, setting a stop above this year’s and pattern highs of $25.14 makes sense. We’d estimate this type of money management should reduce the position risk to about a quarter or half of the premium; and more than we’re likely to get from the Fed sometime this year.
As of this writing, investment accounts under Christopher Tyler’s management do not currently own positions in any of the securities or their derivatives mentioned in this article. The information offered is based upon his observations and strictly intended for educational purposes only; the use of which is the responsibility of the individual. For additional market insights and related musings, follow Chris on Twitter @Options_CAT
