A Utilities Trade/Hedge That Can Make 317%

06/05/2019 8:48 am EST

Focus: OPTIONS

Jay Soloff

Editor, Options Profit Engine

With trade wars ramping up, one trader places a huge bear position in utilities, the one sector that has outperformed the broader market, writes Jay Soloff.

May wasn’t exactly a banner month for the stock market. The benchmark S&P 500 index dropped nearly 6% for the month, although the index is still up about 10% year-to-date. Still, a 6% decline is enough to grab the attention of the vast majority of investors.

There are short-term and long-term concerns driving the pullback in the stock market. Anyone who pays attention to financial news knows the market is concerned about the tariffs imposed on China, and now Mexico. That’s the short-term focus.

A trade war is not good news for the global or the domestic economies. The addition of Mexico to the tariff list is a big deal since it is a far bigger trading partner than China. It may not be an immediate effect, but the headlines are enough to drive market direction in the short-run.

Over the long-run, there are growing concerns that the country may be headed towards another recession. Certainly, the tariffs themselves can have an inverse effect on the economy. But, there may be several other factors leading to an economic slowdown.

Ultimately, a recession would be a bigger deal to the stock market than the tariffs. However, it takes time for a recession to happen. Plus, it may be avoided (or diminished) due to actions by the Federal Reserve.

While we don’t know how the market is going to react to any given news item or scenario, we can see what investors are doing with their money right now. There’s clearly been a major inflow of capital into bonds. Even gold has climbed 2.5% over the last month.

These safe-haven investments tend to be popular when investors start to worry about stock prices going down. Another safe-haven type investment is utilities. The Utility Sector generally include safer stocks to own during more tumultuous times.

So how have utilities done lately? The Utilities Sector SPDR ETF (XLU), a popular fund for trading utilities, is flat for the last month. That’s certainly a lot better than the broad market performance (S&P 500 down 6%). However, the options market may be signaling something entirely different.

Just last week, a large trader purchased 7,000 XLU 55-57 put spreads expiring in July. The trader bought the 57 puts while simultaneously selling the 55 puts for 48¢ per spread (or $336,000 overall) with the stock at $58.24. That means breakeven for the trade is at $56.52.

On a debit put spread like this, the trade makes money if the stock moves below the breakeven price. The max loss is only the premium paid, while max gain is the distance between the strikes ($2) minus premium paid (48¢). That would be about $1 million, or a 317% return.

This is clearly a big trade, but what does it mean? It’s a bearish trade on XLU, so someone may be betting that utilities are going to drop over the next six weeks. Could this be due the economic/tariff news actually getting better (or less bad)?

On the other hand, maybe this is a hedge trade. Someone may own a bunch of utilities stocks and wants to protect them from downside risk or own the broad market and are hedging with the sector that has recently outperformed—a reversion type play. A put spread may be an appropriate hedge in this circumstance since utilities don’t tend to be that volatile.

Of course, we can’t really know for sure. I’m inclined to believe this is a hedge. However, there’s certainly no reason it can’t be speculation. The good news is, whether you believe utilities are going to drop or just want to hedge your position, this is an inexpensive way to do so with high return potential.

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