Market Volatility Bulletin: Spotlight On Volatility In The Materials Sector (And How To Play It)

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Market Intro

CNBC: 1:48PM EST

The rinse-repeat nature of the cycle of optimism and subsequent disappointment on trade talks likely strikes you as somewhere between amusing and nauseating at this point. Today’s MVB will focus on a way to play either a break out or a breakdown in the XLB Sector SPDR.

Basic Materials is leading the SPDRs today – up 2.5% – with Industrials (XLI) a fairly close second around a 2% gain. SPX VIX got down as low as 15.63, popped for an hour or so, and as back near the lows.

Thoughts on Volatility: Materials Edition


Data by YCharts

US materials companies have been hit rather hard in the Cino-American trade negotiations. Steel stocks (SLX), for example, participated in a very big way alongside US equities (SPY) in the late ’16 through 2017’s upward journey.

Since trade disputes began, however, the high-beta subsector has gotten clocked, giving up nearly all its gains.

The XLB is more diverse in its holdings, and as such didn’t carry as high in its 2017 upside march, nor flounder as much since trade became a major item on the Administration’s agenda. Still, though, the last two years have seen much more in the way of risk than reward.

Today’s option example is going to take the position that this round of trade talks will either:

  1. quell market concerns, giving way to a new rally
  2. lead to yet another swift breakdown on flagging sentiment

Keep in mind that as recently as Thursday in the pre-market, S&P futures were down around 2880 on pessimism surrounding trade. So while “good things are happening” today, we’ll give some consideration to the likelihood of a swift reversal in the XLB.

Actually, I’d argue that both countries have political reasons for wanting these talks behind them. Unrest in HK and an impeachment inquiry spring to mind. Who knows what the talks will actually yield (perhaps not much at all), but there’s likely to be a strong positive spin from both nations on what the talks accomplished.

…That may be all the markets really need, is to see these two parties play nice.

XLB Double Diagonal

Buying one options strangle and selling another is referred to as a “double diagonal”. That’s what we’ll be discussing in this section.

I’m going to use the ToS platform for the visuals below. The example is to spur your thinking on a scenario of either breakdown or breakout, and is not meant to be a recommendation for what you should literally do.

Trading volume in the XLB is pretty healthy today – almost 30k as the afternoon session gets underway. The bid-ask on the double-diagonal spread I’ll highlight below is around $.06 wide on four legs. Put/Call balance is quite even on the session.

This trade is fairly conservative as far as options plays go. Certainly you can “go bigger” by simply not trading the outer legs, which would open the trade up in case of a large move, but would also get more risky in terms of losses under the scenario of stagnation on the XLB.

The position above features buying the Nov 1 (weekly) $56.50-$58.50 strangle, and dampening the risk by selling the Nov $56-$59 put.

Good chance you can get that trade done at a $.25 credit.

The blue line above shows what the P&L would look like (given constant implied volatility) at Nov 2nd, after the Nov1 strangle had expired.

The purple line shows P&L based on Oct 11, with both strangle spreads “live”.

This trade features positive gamma – and as such large and sustained realized moves benefit the position. Conversely, stagnation or directionless market chop would harm the position.

Wrap Up

The above method described is a reasonable way to take a long position in gamma on the XLB. The sector is arguably poised for more sensitive movements to the trade talks than the S&P taken as a whole.

Thank you, and I look forward to reading your thoughts or questions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.