Tim Bovee, Private Trader: XLV: End of a trend?

The Health Care Select Sector SPDR Fund (XLV) has been in the midst of a powerful upward push, interrupted only by the most minuscule of corrections, since 2011 The rise has carried the price up 120% in that three-year period.

That health care is a hot sector has become one of the truisms of our age -- Obama's health-care reforms, the huge Baby Boomer generation beginning to retire and enter their peak years as health-care consumers -- everything seems to be conspiring to keep the good times rolling.

But the very length and structure of the trend produces a frisson of fear in the trader's heart. After all, no trend lasts forever.

The Chart

Elliott wave analysis shows the upward push since August 2011 to be an extended 3rd wave. Extended waves are curious beasts, exceptions to the normal impulse wave's internal structure of five clearly differentiated subwaves, with the 3rd wave often coming in as the longest of the three in the direction of the trend.

Idealized wave from from "The Basis of the Wave Principle" by R.N. Elliott

In an extended wave, it is as though the trend is rushing forward like a skier navigating the advanced slope, barely pausing for a correction, with the brief interruption so undifferentiated that it is near impossible to frame it with a wave count. When all waves the same size, how is an analyst to determine which degree each wave is, or which wave is the parent in the pattern and which is the child.

The extended wave on the XLV chart shows just such generational confusion.

Click on chart to enlarge.

XLV 9 years 4 months weekly bars (left), 30 days 2-hour bars (right)

Had I looked at the chart in mid-September, I would have concluded that the trend had possibly reached its end on at $65.31. However, this week's rise carried the price above that level, suggesting that the extended 3rd wave is continuing its upward course.

The break beyond prior resistance is not incontrovertible proof that the uptrend remains underway. There are cases of corrections moving above their starting points. But it will take a decisive drop back below prior resistance to allow that case to be made. Absent such a move, I must count XLV's chart as bullish.

The internal count of movements since the prior resistance suggests that the chart may indeed be less bullish than it seems. As is always the case with new trends, it is next to impossible to put a definitive framing in place because there are hardly any clues to guide the assignment of degree to the waves. I've arbitrarily chose the base degree and one degree down, but I don't really know how accurate that will prove to be.

On Oct. 15 XLV broke below its most recent support level and then quickly retraced to the upside.

What is clear is that since the low of Oct. 15, XLV has traced out five waves to the upside and is in the final wave of the series. If the end of wave 5 also marks the end of the higher-degree wave 3 {+2}, then the ensuing correction will likely be quite significant, potentially shaving 50% or more off the price.

The final assessment will depend upon XLV's relationship with prior resistance over the next few days. If it breaks above that level and moves significantly higher, then the extended wave 3 {+2} is in progress. If it drops back below that level, then the preponderance of evidence begins to shift to the bearish case.

The Fund

The Health Care SPDR ETF tracks the S&P Health Care Select Index drawn from the S&P 500. It covers the industry broadly, but all companies on the index are major players. The top five companies in the fund as represented by percent of net assets are Johnson & Johnson, Pfizer, Merck & Co., Gilead Sciences, and Amgen.

The expense ratio is 0.16%. The dividend yield is 1.36% annualized at today's prices. The fund goes ex-dividend in December for a quarterly payout of 23.08 cents per share.

Liquidity and Volatility

XLV on average trades 17.4 million shares per day and supports a very broad selection of option strike prices spaced 50 cents apart near the money, with open interesting runing to four figures. It also has a series of Weeklys options.

The front-month at-the-money bid/ask spread on calls is 13.7%, compared to 0.6% for the most-traded symbol on the U.S. markets, the exchange-traded fund SPY. My strong preference is for bid/ask spreads of under 10%, so the wider spread is a mark against XLV.

Implied volatility stands at 19%, compared to 16% for the S&P 500 index, and has been falling since Oct. 16. It stands at the 61st percentile of the most recent rise prior to the Oct. 16 peak.

That percentile places XLV in the high volatility category, suggesting that the most successful trades will be structured as long options spreads, bought with a debit and expiring in an out month.

If I were confident in the uptrend, that would be an acceptable structure for the trade. However, as discussed in the "Chart" section above, there is reason to treat the uptrend with great caution at this point.

A far better play, from a defense standpoint, would be a bullish volatility play under my very short term volatility rules. Volatility certainly shows a downward hook since mid-October, and it remains high enough for me to make such a trade. However, it seems to be faltering just a bit the last couple of days and indeed today has taken a slight upturn, not a promising omen in favor of further decline.

Click on chart to enlarge.

XLV with implied volatility, 30 days daily bars

Decision for My Account

I see three big strikes against XL V: The potential for major downtrend to begin soon, the slightly too wide bid/ask spread on options and that pesky upward blip on implied volatility, highlighted in yellow on the chart above.

For those reasons, I'm declining to enter a bull position on XLV.

-- Tim Bovee, Portland, Oregon, Oct. 27, 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.