Update: XLP Spreading Nov Puts

by Dan October 11, 2018 12:21 pm • Trade Updates

On Oct 1st I made a near-term bearish case for consumer staples stocks, via the etf that tracks the sector the XLP (Have You Tried Staples?) suggesting:

The third largest holding, PepsiCo (PEP) is scheduled to report earnings tomorrow morning before the open. The options market is not implying a big move, about 2% in either direction, despite the fact the stock rallied almost 5% the day of their Q2 report in early July,

The other four in the top five will all report Q3 results prior to Nov expiration (PM Oct 18th, PG Oct 19th, KO Oct 30th, and WMT Nov 15th). The reaction to PEP earnings in an investment environment where low growth, high valuation, high paying dividend names are out of favor with the 10-year Treasury yield above 3%, where multinational U.S. manufacturers face headwinds from dollar strength, high input costs and potential adverse effects of a building trade war with China, I would suspect consumer staples could continue to be vulnerable if as a group they post weak results and so-so forward guidance. All five of these stocks trade kind of rich to the market especially when you consider that none are expected to grow eps in 2018 or 2019 above single digits, and all are expected to have sales growth in the low single digits for eternity.

….

Near-term, XLP looks like a good candidate to retrace much of its bounce off of its 52-week lows made in May back towards $50. Options prices in the etf are very cheap, even into earnings season where most of its large components will be reporting prior to Nov expiration. Obviously, there is the potential for the bad reports to be canceled out by the good ones, but given the underperformance of the large components I suspect a few bad ones, by the big ones and we see this group turn lower, no matter what sort of broad market we are in.

 

WIth implied vol so low in the etf, the trade Idea was a simple put purchase when the XLP was $54:

TRADE IDEA: XLP ($54) BUY NOV 54 PUT FOR 85 CENTS
Break-even on Nov expiration:

–Profits below 53.15, down 1.6%

-Losses of up to 85 cents, between 53.15 and 54 with max loss of 85 cents, or 1.6% if the etf is 54 or higher.

Now with the XLP lower and implied volatility higher, it makes sense to lock in some of the gains and reduce the premium at risk:

versus the XLP Nov 54 Put (from Oct 1st)

Action: XLP ($52.80) Sell 1 Nov 51 put at 45 cents

New Position: XLP Long Nov 54 / 51 put spread for 40 cents.

Rationale: the sale of the Nov 51 put creates a $3 wide put spread that can be worth $3 at $51 or lower. It is already $1.20 in the money, and the total cost at risk is now just 40c, so good risk reward.

From a technical standpoint. near-term $51 appears to be the next level of support:

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