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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

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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: sentiment, 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.

Checking the Charts

From a technical perspective, XLV has rebounded along with the broader market during the prior 2 weeks. The shares have gained nearly 13% since tagging a multi-year low of 21.63 on March 6. The ETF's solid price action has pulled its 10-day and 20-day moving averages into a bullish cross - a technical formation that is often the precursor of additional gains for the shares. The shares are now trading above former support at the 24 level, a region that buoyed XLV in October 2008, early November, and early December.

However, there is still the matter of short-term resistance at the 24.50 level, which XLV has not closed a session above since Feb. 26. What's more, the ETF's declining 10-week moving average has descended into the 25 region. XLV has not closed a week above this trendline since mid-February.

Daily chart of the Health Care Select Sector SPDR since October 2008 with 10-day and 20-day moving averages

The Sentiment Drivers

This backdrop doesn't offer a very bullish outlook for the ETF, and options traders tend to agree. XLV's Schaeffer's put/call open interest ratio (SOIR), which measures put open interest against call open interest for the front 3 months of options, arrives at 2.01, indicating that puts more than double calls among near-term options. This ratio also ranks above 89% of all those taken in the past year, meaning that investors have been more bearish toward XLV only 11% of the time in the prior 52 weeks.

This bearish options configuration is supported by data from the International Securities Exchange (ISE) and Chicago Board Options Exchange (CBOE). Currently, the ISE/CBOE 10-day put/call volume ratio arrives at a reading of 1.44, meaning that puts bought to open during the prior 2 weeks have outnumbered calls bought to open.

But, while speculative traders have expressed a preference for bearishly oriented puts, Wall Street brokerage firms have taken a more neutral stance on the health care sector as a whole. Specifically, 52.7% of the 1,205 analyst ratings on health care stocks are "buys," compared to 43% "holds," and 4.3% "sells," according to Zacks. This centrist configuration leaves plenty of room for both upgrades and downgrades for the health care sector.

Sentiment indicators for Health Care Select Sector SPDR

The Verdict? The growing short-term resistance at the 24.50 level makes me nervous in regard to today's XLV credit spread. The sold April 24 put rests less than 2% below the ETF's current trading range, creating quite a bit of risk that a sharp move by the broader market could quickly place this position at a loss. On the other hand, I have not seen any compelling technical or sentiment drivers that would inspire me to take a firm bullish or bearish position on XLV. Traders may want to hold off on jumping into the ETF for the time being.

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