An options trade in materials group for when valuations get too rich
“You can never be too rich or too thin.” The famous quote has been attributed to the two-time American divorcee and Duchess of Windsor, Wallis Simpson, although a few others have also been given credit for the line or something close to it. Doctors might suggest that a person can indeed be “too thin,” and, in the context of investing, securities may occasionally be a bit “too rich.” Examining the performance of different sectors since the beginning of the year, a couple really stand out. The energy sector is up ~19% so far this year; regional banks and materials are up ~13.6%; and consumer staples and industrials are also up double digits. In general, it is healthy for equity market performance to broaden as it has done from technology stocks to these other sectors — and from the megacaps to small(er) companies as evidenced by the Russell 2000 outperforming the S & P 500 so far this year. However, stocks don’t go up in a straight line. They can be oversold or a bit extended in the short-term. Such may be the case right now in materials. Since Oct. 7, 1999, the average 30-day price change in the State Street Materials Select Sector SPDR ETF (XLB) has been ~55 basis points (0.55%). Here’s a histogram of those results, with the column that includes the mean return highlighted in blue. But the picture changes meaningfully when XLB gets extended above its own 200-day moving average. Right now, XLB is in the top decile relative to the 200-day moving average. The histogram for the top decile by this metric looks remarkably different, again with the mean return, now -0.22% highlighted in blue. Selling covered calls on XLB can make sense when two conditions line up: first, the price is stretched as we see now, and second, if option premiums are unusually rich. Right now, 1-2 month implied volatility is ~1.7 standard deviations above its 2-year mean. When an ETF trades far above its longer-term moving averages, it doesn’t guarantee a decline — the histogram above illustrates many circumstances where a rally keeps going. But it does increase the probability of a choppier market, and the mean return over the past 28 years has been significantly lower. If XLB pauses after the strong run it has seen recently, the option’s extrinsic value decays, and you keep the premium, effectively turning a stall into income. Extension also matters psychologically and mechanically. As price gets stretched, marginal buyers often become more sensitive to headlines. For materials specifically, that often hinges on commodity price expectations, and two of the most prominent, gold and silver , have suffered significant setbacks in the past week. Implied volatility is the price of convexity. When IV is 1.7 standard deviations above its 2-year mean, options are expensive relative to their own recent history. That’s important because covered calls are, in plain terms, a short-volatility overlay: you’re collecting premium up front in exchange for giving someone else the right to buy your shares at the call’s strike price. 30–60 DTE calls tend to balance premium, liquidity, and responsiveness to changes in volatility (aka “vega”). The trade As I write this, late March expirations such as the March 20th regular-way expiration or the month-ending March 27th expiration would be suitable. Typically, 20-30 delta call options provide an appropriate balance of return and some potential upside to the short strike. The less “headroom” you think you need, the higher the delta of the short call. With XLB stretched versus the long-term trend and near-term IV unusually high, the market is offering a comparatively attractive trade: sell expensive insurance on an ETF that may experience a bit of near-term indigestion. In that environment, covered calls can improve risk-adjusted outcomes by harvesting premium and forcing discipline on exits — without requiring you to predict the exact timing of a pullback. DISCLOSURES: None. All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, or its parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSTITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
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