XHB: A homebuilders bull play

Update 6/7/2013: XHB gave an exit signal on May 31 and I closed the position on June 7. From initial entry to final exit, the share price gain 0.3%. The position rolled once and added to several times. Shares earned 0.4% overall on my basis. The vertical credit option spreads that I used to construct the position produced a yield on risk of 2.6%.

The SPDR S&P Homebuilders exchange-traded fund (XHB) broke above its 20-day price channel on Thursday and confirmed the bull signal the next day by trading above the breakout level, $30.25.

The break comes amid a sideways correction at the tip of an uptrend that began in October 2011 from $12.21. The correction is in its fifth week, and it will take a break above $30.66 to renew the uptrend. The correction high so far, set both Thursday and Friday, is $30.52.

The sidewinder floor is $27.97, and a break below that level would suggest that the correction is developing into a decline.

This is XHB's fourth bull signal since the current leg up began in June 2012 from $18.93. Two of the three prior breakouts in that period produced profits, averaging 10.8% in positions lasting on average 69 days. The failed trade lasted nine days and lost 6.6%.

Adjusting the winning yield by the success rate produces a score of 7.2%, above my 5% minimum. The win/lose yield spread is only 4.2%.

Since the broad markets began recovering in January 2009 from the post-recession crash, XHB has completed 18 bull signals, only eight of them winners. That produces a success rate of only 44.4%. I'm happier if both the longer recovery period and shorter current trend stats show even odds or better of winning. XHB partially fails to meet that preference.

The average yield of the winning trades, 11.2%, produces a score of 5% when adjusted by the success rate, a minimally acceptable level. The win/lose yield spread is 6.2%, which is OK.

So why would XHB be interesting, even with its mixed odds of success?

Diversity. It's an exchange-traded fund with a wide range of holdings, that that diversification helps make up for the other failings.

The XHB fund's mandate takes the term "homebuilders" further than the way we use it in everyday speech. Its holdings include not only the bricks and mortar gang like Ryland Group (RYL) and Toll Brothers (TOL), but also the kitchenware company Williams-Sonoma (WSM) and the towels and sheets folks at Bed Bath 7 Beyond (BBBY).

My screening methods tend to produce trades that are risky, tightly focused on a niche with a chance of high profits, but also big losses.

So in a respect, XHB is a defensive play because it covers such a wide swathe, and that's a comforting addition to my tightly-focused holdings.

XHB on average trades 7.2 million shares a day and supports an excellent selection of option strike prices. Open interest runs to the four figures for the strikes I would be trading.

Implied volatility is running at 25% and has been declining since mid-April. Options are pricing in confidence that 68.2% of trades will fall between $28.28 and $32.68 over the next month, for a potential gain or loss of 7.2%, and between $29.42 and $31.54 over the next week.

Put options are trading at five times their five-day average volume, and calls are 11% above the average.

The fair-price zone runs from $30.37 to $30.48, encompassing 68.2% of transactions surrounding the most-traded price, $30.43. With 4-1/2 hours left before the closing bell, XHB has traded almost entirely within the zone and is presently above the most-traded price.

XHB goes ex-dividend in June for a quarterly payout yielding 0.8% annualized at current prices.

Decision for my account: I've opened a bull position in XHB, structuring it as a vertical credit spread expiring May 18, short the $30 put and long the $28 put. The spread gives me a 2.9% cushion below the entry level before it becomes unprofitable at expiration. The maximum potential yield is 16.3%.

References

My trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

At several points in my analysis I use the number 68.2%. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

Disclaimer

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.