XLF: A tale of the three charts

Three of the interesting bull signals I found in analyzing 155 high-volume symbols from Monday's markets were exchange-traded funds. One, SPY, tracks the S&P 500 and so is an avatar for the entirety of the stock market, or at least the part that counts.

The other two are sector funds: XLF for finance and XLP for consumer staples.

Of the three, I'm focusing my analysis on XLF -- the Financial Select Sector SPDR Fund. It has a higher beta, a measure of volatility, than the other two ETFs. Volatility is the Mother of profit. A trader must always respect Mom.

XLF also has a strong bull rating from Zacks; the other two ETFs are rated neutral. I always like to have Zacks in my corner.

XLF began an uptrend from $15.08 in November 2012, culminating in a peak of $20.83 on July 23, 2013. From that point it swung into a correction to the downside, hitting a low point of $19.44 on Aug. 28, and then resumed its upward course

Using Elliott wave methods, I count the decline from July to August as five waves of a downtrend: waves i, iii and v to the downside, and waves ii and iv correcting to the upside. That means the present wave up, wave B, will be either a zig-zag with a degree of upward movement, or a flat, which will tend to be a net move sideways.

In either case, if my count is indeed a correct reflection of the mind of the market, the present wave up ought not to exceed the wave ii peak, $20.84, touched repeated on Aug. 1 and Aug. 2. That gives XLF about 2% of upside potential, at best.

XLF 1 year daily bars (left), 90 days 2-hour bars (right)

XLP 1 year daily bars

The consumer durables ETF, trading under the symbol XLP, has a similar pattern. It peaked in May and then moved into a correction, one structured as a flat running between $39 and a bit shy of $42.

The outlier is SPY, tracking the S&P 500, the most liquid symbol on the exchanges, the one that reporters are referring to (along with its venerable uncle DIA, tracking the Dow Jones Industrial Average) when they talk about what the market did today.

SPY hit a peak in May (like XLP), and then another peak in early August (like XLF), and then a third peak on Monday.

That's a high followed by two higher highs and higher lows. In the classic definition, that's an uptrend.

By my count, it seems fairly clear that SPY completed a five-wave uptrend in August.

But sometimes corrective waves will move higher than the end of the uptrend they're correcting. Sometimes, trends celebrate a last hoorah.

SPY 1 year daily bars

I frankly don't know what exactly to make of the divergence. It is a truism that not all sectors move in lockstep. But it is also true that the larger a company is and the more liquid its stock, the less likely it is to march to the beat of a different drummer.

The three charts, viewed together, look suspiciously like one sector peaking and then dropping off, and another coming along to do the same. For the big-picture S&P 500, it looks like a series of higher highs. Actually, by that interepretation, it is really a series of segments losing momentum.

The lesson for XLF is that if SPY can exceed its wave 5 high, then XLF can do the same. It's just, there are no guarantees. Elliott wave doctrine says it shouldn't.

If XLF does resume its uptrend, it has even odds of producing a profitable trade. It has completed four bull signals since the uptrend began in November 2012. Two made money, and two didn't.

The successful trades on average earned 6.2% over 45 days. The unsuccessful ones lost 0.6% over 23 days.

Even though the odds are even, the 5.6% win/lose yield spread makes XLF an attractive bull play.

XLF was one of four ETFs that I found in a narrower than usual search for trades. (See "Tuesday's Prospects: Quill pen edition".) I've discussed two of them, XLP and SPY, above. The fourth was FAZ, which is an ultra bear fund tracking the inverse of the Russell 1000 index.

XLF's five largest holdings read like a Who's Who of banking: Berkshire Hathaway, Wells Fargo, JPMorgan, Bank of America and Citigroup. There's also some insurance tossed into the mix further down.

In terms of volatility, XLF moves like the S&P 500 on steroids. It's beta is 1.50, meaning if the S&P 500 goes up N points, XLF goes up N plus 50% more.

XLP, by contrast, has a beta of only 0.59, meaning it habitually moves less than two-thirds the distance of the S&P 500. SPY, which tracks the index, by definition has a beta of 1.00.

XLF on average trades 34.1 million shares a day and supports an amazingly wide selection of option strike prices spaced $1 apart, with open interest running to five and six figures in the areas where I would construct a trade.

The front-month at-the-money bid/ask spread on calls is extremely narrow, at 0.4%

Implied volatility stands at 14%, in the bottom half of the six-month range. It took a big tumble from Sept. 3 but bounced back up a bit on Monday.

Options are pricing in confidence that 68.2% of trades will fall between $163.71 and $177.91 over the next month, for a potential gain or loss of 4.2%, and between $167.40 and $174.22 over the next week.

Those figures illustrate the problem with the big ETFs: They tend to have lower implied volatility than individual stocks do, and that limits profitability.

Call options today are trading 40% above their five-day average volume, and put options are at 88% of average.

XLF goes ex-dividend Sept. 20 for a quarterly payout yielding 1.51% annualized at today's prices.

Decision for my account: I'll be interested in XLF if it moves decisively above its July high, $20.93. Failing that, I judge that there's a greater likelihood of a significant downturn in the near future. I've added it to my watchlist and will consider a trade if it moves above that level.

References

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

I use the number 68.2% in using applied volatility to calculate the expected trading range. 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.

Elliott wave analysis tracks patterns in price movements. StockCharts has a good explainer. The principal practioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading. 

By preference I place my trades in the last half hour before the closing bell in New York. See my essay "When is the best time to trade" for a discussion of the practice.

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.