As markets have gotten choppy lately, I’ve been on the hunt for more bearish and neutral trades to help balance out my predominantly long portfolio.
In this week’s Follow the Flow report, Steve Strazza teed up a nice candidate for some downside exposure. The beauty is, the Options Gods are lining it up such that we can affordably take an aggressively bearish position that will pay off nicely if it works, while limiting our risk if we’re wrong.
One of the areas we see showing signs of toppy-ness with the potential to lead the market lower is retail.
Here’s what Strazza had to say about the Retailers Sector ETF $XRT:
Next, is the S&P Retail ETF $XRT which saw some heavy bearish options flow last week:
Note that since the beginning of the year, XRT has been stranded in a holding pattern, unable to overcome its pivot highs near 96. Also, notice the nasty potential bearish divergence as momentum wanes lower despite the incremental highs in price.
Sellers have been defending this level like clockwork. There is clearly plenty of overhead supply at this area. At the same time, buyers remain aggressive and continue to retest this key resistance zone.
This setup is very binary. If buyers can’t get it done, it’s only a matter of time until sellers take control and send prices lower.
With the risk/reward so well-defined at current prices, we can be short if we’re below 96 with a target of 69 over the next 2-4 months.
Complacency has set in as observed when looking at how implied volatility in $XRT options has trended since the start of the year:
We’ve seen a modest uptick in recent weeks, but nothing signaling any fear or bearish anticipation.
This sets up the potential for a powerful winner with long puts if we nail it.
Here’s the Play:
I like $XRT Long December 85 puts for approximately $3.25 per contract. These puts sport a 25 delta and will be well positioned if $XRT makes a run at the 69 downside price target Strazza mentioned above.
Our risk in this trade is limited to the premium we pay at the onset. We can’t lose any more than that. However, we’ll be looking to close this trade and salvage any premium that is left in these puts if $XRT trades up above $99 per share. That is our signal that we’re wrong and its time to get out.
If $XRT collapses, we’ll be looking to sell half of our puts when I can get $6.50 for them. That would be a doubling of my invested capital and selling half of our position removes all of our original risk capital from the trade. Then, I’ll continue holding the rest either into expiration month (December). If we’re lucky enough for the 69 price target to be touched, I’m going to close the position and book the healthy win. Bear market bounces are swift and brutal. I don’t want to leave myself exposed to such a reversal.
If you have any questions on this trade, please send them here.
P.S. We do trades like this regularly. If you’d like to leverage Best-in-Class technical analysis into smarter directional options trades, try out All Star Options Risk Free!