Options Update: Health Care Select Sector SPDR Hit with Credit Spread

Option traders bet on a bottom for the health care sector

by Joseph Hargett (jhargett@sir-inc.com) 3/24/2009 1:45 PM


Keywords:

XLV

stocks

options

Traditionally, the health care sector is seen as a relative safe haven during troubling economic periods; people get sick, people need health care. The group has held up better than the rest of the market, with the Health Care Select Sector SPDR (XLV: View sentiment for XLVsentiment, chart, options) exchange-traded fund (ETF) losing more than 8% on a year-to-date basis, compared to the S&P 500 Index's (SPX) drop of about 15% for the same time frame. In the options pits today, however, it would appear that at least 1 trader/institution is betting that the health care sector has seen the worst that 2009 has to offer.

Specifically, more than 20,000 puts have traded on the XLV so far today, outpacing the ETF's daily average by more than 9 to 1, and placing the shares on our Intraday Volume Explosion List. Digging a little deeper reveals that nearly all of this volume changed hands at the XLV's out-of-the-money April 23 and 24 puts. Volume at these strikes outnumbers open interest, suggesting that the ETF is seeing the addition of fresh positions. While put activity normally denotes a bearish stance on the underlying security, today's volume appears to be part of a credit spread - a neutral-to-bullish options strategy.



Health Care Select Sector SPDR option volume details

The Anatomy of a Health Care Select Sector SPDR Credit-Spread Position

A bullish credit spread involves selling a higher-strike put and purchasing a lower-strike put. This results in a net credit to the investor's account. The maximum profit is achieved as long as the sold put stays out of the money by expiration. In today's example, the trader needs XLV to stay above the 24 level by the close of trading on April 17, when these options expire.

So, how does today's example work on paper? First, the trader purchases the April 23 puts for a debit of $380,000 -- ($0.38 * 100)*10,000 = $380,000. Next, the trader sells the April 24 puts for a credit of $680,000 -- ($0.68 * 100)*10,000 = $680,000. A total credit of $300,000 for the position is arrived at by adding the credit received from selling the April 24 puts and the debit incurred for purchasing the April 23 puts -- $680,000 - $380,000 = $300,000.

Hedging Your Bets

So, why not just sell the April 24 puts outright and collect the entire premium? Well, the purchased April 23 puts act as a form of insurance against an unexpected plunge in the position. Once XLV breaches the 24 level, the sold 24 put becomes a liability, and continues to lose money until the shares breach the purchased 23 put.

By entering this trade, the investor expects XLV to hold above the 24 level for the next several weeks. The shares retook potential support at the 24 level during yesterday's trading, but short-term resistance in the 24.50 area is causing problems for the ETF. That said, let's see if XLV's technical and sentiment backdrops provide any additional drivers for this trade.

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