Tim Bovee, Private Trader: XLP: Informed or clueless?

The Consumer Staples Select Sector SPDR Fund (XLP) has been on the rise since February and today hit a new high.

It is a subset of the S&P 500, which last hit an all-time high on Sept. 19. Are consumer-sector traders smarter than the rest of us? Or have they just not gotten the message? Are they informed, or simply clueless?

The Chart

Elliott wave framing shows XLP as working its way through an extended 3rd wave.

Extended waves happen when exuberance, sometimes irrational sometimes not, in the direction of the trend reaches such levels as to overwhelm the normal pattern of corrections seen in most trending movements.

The trend is interrupted only by shallow corrections, and all of its components are of a magnitude so similar as to make it nearly impossible to render a meaningful count.

Click on chart to enlarge.

XLP 10 years weekly bars (left), 9 months daily bars (right)

The right-hand chart shows one way to count the extended 3rd, but there are other counts possible, each one arbitrary and adding nothing to the already available information.

XLP has been in a solid uptrend since the 2009 Great Recession low. That uptrend, in turn, is the middle wave of a rise that began in 2003, which I've labelled as wave 3 {+3}.

As I drill deeper, I find that wave is in the final leg, wave 5 {+1} of its middle portion, wave 3 {+2}.

Within wave 5 {+1} is a pattern that provides good news for traders who hope the trend continues: A series of 3rd waves down at least three degrees, the lowest being wave 2 {-2} from Oct. 2, and the 3rd of largest magnitude being wave 3 from Feb. 3.

No trend lasts forever. The pattern means that the correction to come (as corrections inevitably do) will be followed by an additional rise, wave 5, that will move past whatever peak wave 3 eventually attains.

For shorter term traders, the charts signify a lot of upside momentum, generally a good thing for turning a quick bullish profit.

Odds and Yields

XLP has completed two bull signals since wave 3 began in February 2014. One was successful, yielding 5.2% over 150 days. The other was unsuccessful, losing 1.4% over 18 days.

The difference in duration nicely illustrates the exuberance toward the upside -- a bull signal lasting nearly half a year vs. a bear signal over in less than a month.

The Fund

The Consumer Staples Select Sector SPDR, run by State Street Corp. (STT) of Boston, Massachusetts, invests in household names of the kitchen shelf and bathroom cabinet. The five largest holdings, accounting for more than a third of net assets, are a litany of Big Consumerism: Procter & Gamble, Coca-Cola, Philip Morris International, Wal-Mart Store, CVS Health.

The expense ratio is 0.16%, compared to 0.09% for the S&P 500 index exchange-traded fund SPY.

XLP's dividend yields 2.49% annualized at today's prices, compared to 2.33% for 10-year U.S. Treasury notes. The fund goes ex-dividend in December for a quarterly payout of 28.65 cents per share.

Liquidity and Volatility

XLP on average trades 10.5 million shares per day and supports a moderate selection of option strike prices spaced a dollar apart, with open interest running to three figures near the money.

The front-month at-the-money bid/ask spread on calls is 3.7%, compared to 0.5% on SPY, which is the most-traded symbol on the U.S. markets.

Implied volatility stands at 14%, compared to 18% for the S&P 500 index, and has been stairstepping higher since falling from its Oct. 1 high of 15%.

XLP's volatility stands at the 84th percentile of the prior rise from mid-September to the beginning of October, implying that the most successful trades will be structured as vertical option spreads sold for a credit and expiring in the front month.

Options are pricing in confidence that 61.8% of trades will fall between $43.64 and $47.46 over the next month, for a potential gain or loss of 4.2%, and between $44.63 and $46.47 over the next week. I've marked the one-month range in blue on the right-hand chart.

Contracts are trading heavily today with heavy skewing toward calls, which are running 135% above their five-day average volume. Puts are trading 2% below average volume.

Decision for My Account

At the outset of this analysis I noted the discrepancy between XLP and the S&P 500, and asked whether XLP traders were smarter than the general run of traders or just hadn't gotten the message. I'm guessing the latter.

As I was writing the analysis, XLP reversed course and fell sharply back into its 20-day price channel, negating the bull signal and taking it off of my list of prospective trades.

Had upward momentum continued, I would have taken the trade. Volatility that is high relative to its recent history with high liquidity and an excellent choice of options is just too good a play to pass up.

But with the signal negated, my conclusion is, no trade.

-- Tim Bovee, Portland, Oregon, Oct. 9, 2014

References

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

From time to time 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. The principal practitioner 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.

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.

See my post "Chart Analysis: Nomenclature" for an explanation of my method for labeling waves on the chart.

By preference I place my shorter-term 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 decisions for his or her own account, and take responsibility for the consequences.