Monday, February 25, 2008

The XLF and the SPX

After I penned (keyboarded?) The Rising Popularity of XLF Options on Friday, I was please to see that a number of other bloggers picked up on the XLF theme and weighed in with some interesting commentary. One post I found particularly noteworthy was from Bob Barnes at bzbtrader. In his aptly titled, Deconstructing the XLF, Bob breaks down the top holdings of the XLF, dissects the open interest, and discusses trends in short interest as well. (If you click through, don’t stop with the XLF post, as Bob does an excellent job with a broad range of charting and TA issues and should be required reading for anyone who follows the QQQQs.)

Another thing to think about vis-à-vis the XLF is the relative performance of this sector to the broader indices, like the SPX. In the chart below, I have graphed a ratio of the XLF to the SPX, with a blue area chart of the SPX added for context. As financials are still the largest sector component of the SPX, it is not surprising to see these two indices move in the same direction. When the XLF and the SPX diverge, however, investors should pay close attention. The divergence from May to October is notable, for instance, with the decline in the XLF perhaps providing a warning that the market was topping during this period. Another interesting period is in early February, when the SPX rose in spite of a falling XLF. Now it appears that both the SPX and XLF are moving sideways in unison. For what it’s worth, I don’t expect the SPX to be able to stage a significant rally without dragging the XLF along for the ride or perhaps even following the financials back up.

So watch the XLF in absolute terms, but also keep an eye on the performance of the XLF relative to the SPX.


Anonymous said...

I tried to ask BZB but I'm not a goog blogger so can you help me understand his info? P/C OI has fallen dramatically but shares sold short has risen rapidly--along with the trading volume of XLF. Doesn't that imply traders are opting for the 'riskier' trade against XLF by outright shorting (and suffering the dividend and the momo 7-8% days) rather than the more controlled risk of options? Sounds like a nice recipe for a well executed short squeeze. Cue Gasparino!

Bill Luby said...

Hi dowoper8tr,

Frankly, I was quite surprised to see the P/C numbers from Schaeffer. I expected to see a lot more evidence of long put activity.

The short action is not surprising and appears to have been the preferred way to play this one. As you point out, the dividend makes for a fair shorting hurdle, but I suspect that in terms of risk, the big boys have been looking at a much higher potential for significant gaps down than up (if so, they were right on target.)

I have no position in XLF and have preferred to play with fire directly here: MBIA, WM, LEH, COF, etc.

I also think that the bulk of the downside opportunity in financials has already passed us by. I'm looking at going long some foreign and regional banks right at the moment, FWLIW.



Unknown said...

One significant advantage that the VIX has over a sector XLF as a hedge for the SPX (or SPX-like portfolio), is that it's a general-purpose hedge.

And at some point the downtrodden sector will snap back and cause the hedger to miss out on bulk of the market rally, and possibly lose more money on the hedge than gain on the main portfolio.... for example, good news about Ambac could make the XLF rally harder and higher than the SPX.

Put another way, a sector hedge is not so much a pure hedging strategy as it is a pairs trade (and it has to be managed/timed as such), whereas a VIX hedge is more like catastrophic loss insurance. :)


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