Like many sectors, the consumer discretionary sector has enjoyed a strong year, rallying more than 16% in 2023. However, markets have enjoyed an almost vertical rally in the last two months and are due for a reset. The chart below shows the Cboe Volatility Index (VIX) , Wall Street’s preferred fear gauge. You will notice that it is hovering near five-year lows. Although low VIX values bring market rallies, volatility is a mean-reverting phenomenon — and extreme VIX values also coincide with market tops and bottoms. Against this backdrop, one sector to watch is consumer discretionary. When the economy is good, interest rates and inflation are low, consumers have more free cash flow coming in, and that increases their spending power. However, macroeconomic and geopolitical events can affect the consumer’s buying power and willingness to pay higher prices for goods. One such geopolitical event unfolding right now is the Houthi attacks on shipping in the Red Sea, which can cause a complex chain reaction and have a range of consequences on retail prices. With this view in mind, I am looking to put on a bearish options trade on the Consumer Discretionary Select Sector SPDR fund (XLY) , which tracks the performance of the S & P 500 consumer discretionary sector. I am using an indicator called the relative strength index, or RSI, to provide confirmation to my bearish bias. Note that the last two times XLY was in the overbought zone, it was followed by a significant pullback. The RSI for XLY is again in overbought territory and is about to drop below the 70 line. This usually indicates that an uptrend is about to reverse. The trade setup: XLY 181-182 Bear Call Spread With a bearish directional bias in place, the trade structure I have chosen is called a bear call spread, also known as a call credit spread. To construct my trade, I will want to sell a $181 call option and buy a $182 call option as a single unit. When selling credit spreads, you bring in a premium when you open the trade. If the trade goes in your direction, you get to keep that premium. Strike selection When selling call or put credit spreads, it is best to look for strikes that will bring in a credit that is at least 1/3 of the width of the strikes. In my case, the width of my strikes is 182-181 = $1, so the premium I would want for this trade is 30 cents (Or $30 due to the 100x option multiplier). With this trade I am betting on XLY not going above $181 on expiration day. Here is my exact trade setup: Sell $181 call, Jan. 26 expiry Buy $182 call, Jan. 26 expiry Credit: $30 Risk management Credit spreads are high-probability trades. This means that you can expect seven of 10 trades to become winners. However, there is a catch. The winners will bring in small profits which will add up over time. The losers will bring in large losses. In theory, the three losers will cancel out seven winners. One will need to have a risk management plan in place so that the losers are cut at predefined levels before they become too big. By having an effective risk management plan, these trades can be very rewarding over time. -Nishant Pant Founder: https://tradingextremes.com Author: Mean Reversion Trading YouTube, Twitter: @TheMeanTrader DISCLOSURES: THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE 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.
This story originally appeared on CNBC
