Noah Would Have Bought CALLs (XLU, SPY)

We’ve got one trade to close before we get down to business this week. It was a winner, thank the Lord, not a grand slam homer, mind you, but a nice turn of profit.

It was an initiative we booked back on February 24th, just prior to the broad market top-out and at the end of what we figured would also be a top for the Utility sector.

The letter was called Downside betting on Freeport and the Utilities, and there we wrote as follows –

[W]e see the longer term picture is bullish, despite any temporary stall that may be upon us. RSI and MACD are above their waterlines and all the weekly MAs are unfurled and trending higher. In sum, the utilities should continue to rise, but after their most recent burst, may be due for a short term pause.

And, in short, we were wrong.

The utilities, as represented by the Select Sector SPDR Utilities ETF (NYSE:XLU) did exactly the opposite of what we expected, continuing to rise through last week and setting new 52 week highs along the way at $43.52, before eventually losing power this past Friday and dumping by over two percent.

The rise came first.

And the question remains – will the decline, follow?

Starlet

Actually, it’s not looking bad at all.

Remember, we purchased the XLU January 2015 41 CALL for $1.40 and sold the January 2015 42 CALL for $0.92, for a total CALL side debit of $0.48.

Today, those number look like this – the 41s are going for $2.34, and the 42s trade for $1.81. And there’s no doubt we’re going to catch some flack for recommending the following action on this side of the trade.

We want you to close your long 41 CALL at $2.34 and let your 42s ride for the time being.

What?!

That’s right. Leave them dead alone.

Sure the move entails some risk, but we believe our rationale is sound. Our reason for playing it thus resides in the charts. Have a look –

xlu5514

As you can see, all the major moving averages are unfurled and trending higher – a clearly bullish phenomenon. And with price above them all (red circle), we couldn’t ask for a better technical read from the MAs.

The only problem is, with price now cruising at levels 14.5% higher than the long term moving average (red arrow), we have a situation that’s more stretched than at any other time since the bull market began back in March 2009. The only other read that approached current levels was in May of last year, when the utilities soared 14.3% above their long term MA, stalled and promptly dropped that same 14% back to the long term moving average.

Moreover, it’s significant that volume surged with last Friday’s decline – an event that certainly needs a few more days of confirmation to prove anything, but can stand alone is a technical marker of some value. Taken together with the precipitous drop in the relative strength indicator (RSI) on the same day (in black) and we say traders’ attention will be fixed on whether MACD confirms with its own downward move.

Should that occur, we’ll be in the midst of a sustained (14%) withdrawal to strong support at $38.

conehead

In short, we feel safe in closing the long CALL portion of our trade and leaving the short CALL to lose time value as XLU declines, an eventuality that looks more certain to transpire in coming days.

B Side

As for the PUT side of the trade, you’ll remember that we bought the XLU June 38 PUTs for $0.55 and sold the June 37 PUTs for $0.33. Debit for the PUTs was $0.22 per pair.

And how’s it looking now?

Simply put – un-tradeable.

The spreads on the options are so wide that it’s unrealistic – a losing proposition, in fact – to do anything at all with them. We’re going to wait until a pullback tightens the bid/ask and gives us a more realistic closeout option.

In the meantime, our long CALLs have bagged us a 67% profit in two months.

This Week’s Trade

We’ll introduce our trade for the week by quoting a recent letter from a friend, who, in responding to Normandy’s ultra-bullish take on the market, wrote –

“This time it’s different…” was a sentiment repeated often in the 1999~2000 era of irrational exuberance, which was referred to as the DotCom Bubble. I’m trying to recall what triggered the selloff and resulting losses… People like Mark Cuban did well by getting out near the top – always a hat trick. I hope people in the Irrational Exuberance game today are following events in Eastern Europe…….we seem to be heading for a very large war.

Could be, dear friend. Could be very large.

But will it upend the market, is the question.

And we say no.

We also say that our dear friend may be old enough to remember that former, former Fed Chairman, Greenspan uttered the phrase ‘irrational exuberance’ some three and a half years before the market finally topped and the DotCom bubble was burst.

Three and a half years of the market rising irrationally is, at the end of the day, three and a half years of gains. And our take is that the rise this time will absolutely dwarf the DotCom bubble mania of the late ’90s. This will be the greatest blowoff top the market has ever seen.

Betting on Liquidity

The flood today is not the biblical torrent that drowned the world in Noah’s day, friends. Today’s flood is all-cash.

And your ark is a long-term, deep-in-the-money CALL on the broad market.

Wall Street Elite recommends the following trade for your consideration – buy the SPDR S&P 500 ETF (SPY) December 2016 110 CALL options, now trading for $81.36 each. And sell the December 2014 SPY PUTs for $4.15. Total debit on the trade is $77.21.

This should be a core holding, earthling. Allow up to 20% of your portfolio to be dedicated to the trade.

With kind regards,

Hugh L. O’Haynew
Senior Analyst
Normandy Research

Share your thoughts...

We encourage people to join in on the discussion. Please keep in mind however, that all comments are moderated according to our comment policy, and all links are nofollow. Let's keep the conversation professional and meaningful.