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Morning Update

Overnight another Greek bailout was agreed to, which has sent the Euro lower against the dollar. In the past these events have been a “buy the rumor, sell the news” events, so today’s price action is no surprise. And as with the past Greek bailouts, analysts are already saying that it is just kicking the can down the road without a real solution. The main economic news out of the US this morning is the durable goods numbers, which came in ahead of expectations, though expectations were exceptionally low. The October number was unchanged following a 9.2% increase in September and massive 13.1% drop in August. The chart from the Federal Reserve, shows capital goods orders with formal US recessions highlighted in grey. If the recent drop in durable goods orders continues, the trend shows that the US is likely headed for a recession.

One of the sector’s hardest hit since President Obama’s reelection has been the Utilities. The SPDR Select Sector Utilities ETF, XLU, is down 4.8% versus a 0.60% decline in the S&P 500 since the election. Yesterday one option trader made a bet that this sell off was overdone and that the XLU is due to rally into the end of the year. The biggest trade of the day was the purchase of 36,766 Dec. 35 calls for $0.23 with the stock at 34.56. This is a bullish bet that will profit if XLU is above 35.23 (1.9% higher) at December expiration in 24 days.

The utilities sector has sold off since the election on fears that taxes on dividends will rise. The utilities sector has traditionally paid some of the highest and most consistent dividends in the market, but will lose some appear if dividend tax rates increase. However, at current prices the utilities are starting to look like a bargain, which has led this option trader to make a bullish bet.

By buying the Dec. 35 XLU call option, this trader has locked in the ability to purchase the ETF at 35 at December expiration. At this level the stock will yield 3.8%. Historically Utilities have traded with a discounted yield to investment grade corporate debt, but ITR, the SPDR Barclays Intermediate Term Corporate Bond ETF, is currently yielding just 3.2%. This could be a sign that XLU has been oversold and due for a pop. If the XLU were to move higher such that it yielded 3.2% like the corporate bond ETF, it would be at 41.00, or 19% higher than yesterday’s close.

Considering the XLU has a better yield than investment grade corporate bonds and also, unlike bonds, maintains the opportunity for significant capital growth, buying calls here is a low risk, high reward trade that locks in what is likely to be an advantageous entry point.


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