Lagging sector looks poised for a rebound. Here's how Mike Khouw is trading it
You can't judge a book by its cover. And in the case of the stock market, you can't judge a sector by its name, which could be creating a compelling opportunity in the options market. Let me explain.
All market sectors have some diversification; industry and sub-industry groups may differ and respond differently to broader sector drivers. Sometimes those differences, while distinct, still touch the same product in some way. Consider the energy select sector index; it includes upstream (E&P), midstream (pipelines & logistics), and downstream (refining and marketing) industries, or companies that span all of these, like integrated oil companies and services. Global dynamics may favor one industry over another within the sector, but they're different positions on the same playing field. Consumer discretionary as a sector encompasses a wide array of unrelated products and services, but the common denominator there is demand. When consumers are pinched, they spend less. It doesn't matter whether you sell cars, refrigerators, yoga apparel, cruises, coffee, or gaming. What they have in common is that consumers need a little extra cash in their pockets to buy them, and that's enough.Β
The most peculiar and internally incoherent sector is Communication Services. Ostensibly, what connects them is that its companies "facilitate communication" or distribute content, but that definition is so broad that it groups businesses with radically different economics. The sector includes Alphabet and Meta, whose revenues come from digital advertising, AI, data, and cloud (in Alphabet's case, particularly). What do those two have in common with Verizon, AT&T, and T-Mobile, which operate regulated, capital-intensive telecom networks? Or Netflix, Disney and Fox for that matter?
Its seemingly haphazard construction may be one of the sector's strengths, lending the somewhat compromised basket some diversification and, as an adjunct, low volatility. Given the sector has underperformed the S&P by more than 14% year-to-date, one might argue the broad index offers better diversification and slightly lower volatility.
Perhaps, but quietly, communications has started to claw back some of the year's underperformance. Where the S&P has been largely treading water this quarter, the communications sector has quietly caught a bid, generating nearly 6.5% total returns, enough to outperform the S&P total returns by more than 5%.
XLC, the communications sector ETF, bounced off the $105 level twice in the past several months, giving us some lines to draw in the sand and set up an options trade, specifically the January 105/115/125 call spread risk reversal, selling the $105 strike put, the level off which XLC bounced, buying the $115 call, essentially where we are now, and selling the $125 calls, giving some room to reach new highs if the rally should continue.
The structure basically allows you to get long the $115 call for just over $0.30, a big discount from its $4.35 price. Of course, in exchange for reducing your costs, your upside will be capped at $125, and you could be forced to buy the stock for $105 should it fall below that level. But by selling those two options, you have effectively bought a $10-wide call spread for just $0.30. Of course, being short that put will tie up some margin, so be aware that there are some additional costs associated with this structure.
Disclosures: Tidal owns/holds all the securities mentioned in the article.
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