Bounce Back With 122.6% From This Trade

Wall Street is suffering from a problem of perceived risk. Investors are all out of sorts right now with so much news to digest… from the government shutdown to the trade war. But there’s another story affecting many of the normally risk averse crowd of investors: retirement savers.

Historically, there’s one sector of the market that is almost universally independent from the larger risk picture. Utility stocks are a staple in retirement accounts for two reasons.

First, like their name suggests, these companies are utilities. You can’t live without them in your personal life no matter how much you’d like to. They always get theirs. And most operate as near monopolies, giving them regulated and fixed rates of income.

The second reason these utilities are always so prevalent in retirement funds is because of this income. Those normally fixed rates let these kinds of companies know well in advance how much they’ll make each quarter. That lets them pass on that income with relative surety to shareholders. Those nearing or in retirement can rely on those dividends without worrying they’ll dry up anytime soon.

All of this brings us to this first chart:

xlu

As you can see, XLU (an ETF made up of 28 different ETFs) is actually up over the last 12 months. The S&P 500, in gold, has not performed so well.

That perceived risk in the overall stock market compared to the relative safety of utilities has started to change, however.

PG&E Corporation is one of the largest utilities in the country, covering a huge portion of gas and electricity supply for California. Unfortunately, with the extremely disastrous wildfires over the last year all across PG&E’s coverage area, the company is in dire straits.

The utility is facing safety violations, sky high insurance liability for these violations and now extreme credit risk. Standard & Poor’s just cut the company’s credit rating to junk status. Its stock is down 66% from its 2018 peak. There’s even talk of bankruptcy.

Clearly, considering the type of investor that owns shares of a company like PG&E, this is devastating. This is clearly a company with risks. And this eye-opening collapse has put pressure on utilities across the board. Investors, despite remaining skeptical of the overall stock market, have been steadily unloading utilities over the last month:

xlu2.gif

This above chart is rare. When the S&P 500 falls, utilities can follow suit. But almost never do they fall harder than the overall market. This is almost completely because of PG&E’s problem.

There’s a giant catch here. And it brings us back to the problem of perceived risk…

One Bad Apple Spoils the Bunch

First, PG&E is not a prime example of the entire utilities sector. The company’s equipment might have been what actually started the Camp Fire that killed at least 86 people in November. That’s not something that you’d call common amongst all utilities.

PG&E is also more than $18 billion in debt. To put that in perspective, the company brings in less than $2 billion each year… paying more than half of that out to shareholders in dividends. Now, plenty of utilities are leveraged because of their steady income streams. But with these kinds of liabilities and investigators digging into its “safety culture,” this is clearly an exceptional case.

Finally, when you consider the above charts of the Utilities Select Sector SPDR ETF (XLU), keep in mind that PG&E only makes up 1.8% of its holdings. In terms of percentages, that makes PG&E the ETF’s 23rd largest portfolio position out of 28. Yet, you can see what the recent stock collapse of PG&E has done to the rest of the sector as a whole.

There’s a bounce-back play here if we ever saw one. The market is still in confusion about what the 2019 investment picture should look like. Many are pointing to record holiday retail sales and potential truces in the trade war as catalysts for a fantastic new year. Others are pointing to the fact that the federal government isn’t even open for business right now and weak economic news from across Europe and in China as a bearish signal.

In uncertain times like these, utilities do well. Investors seek safety in dividend paying investments. And they’ll certainly come back to these great income stocks. The perception that all utilities have the same risk as PG&E will soon dissipate. We expect a strong bounce to put this sector back onto the path it was riding before the California wildfires took down that one giant.

So, how do you play this bounce back?

A Strategy For Short Term Bulls

A bull call spread is type of trade we’ve often spoken about. The reason is simple: the strategy can offer great returns on the amount at risk, while lowering the entry cost to get in compared to regular stocks or straight call options.

The way it works is simple. A trader buys a call option with a strike price close to the current price of the stock he’s bullish on. He then sells a call option with a higher strike price to offset some of the initial cost of the first option.

This results in capped profit potential… but also significantly reduced cost and risk.

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Source: The Options Industry Council

Speaking of which, the cost to enter this kind of strategy is the total amount the trader has at risk for the duration of the trade.

The profit potential is found by taking the difference in strike prices and subtracting out that initial cost. Whatever’s left is his profit on the trade if the underlying shares rise in price.

Let’s look at a specific example…

A Specific Trade on XLU

If a trader wanted to use this strategy to play XLU, he could buy January 18 $53 calls for $0.48 per share and sell January $54 calls for $0.17 per share for a cost of $0.31 per share. Since each contract represents 100 shares, his total debit for this trade is $31.

That $31 is all a bullish trader would have to lose by choosing this trade over buying shares of XLU or outright purchasing a call option. That’s his total risk.

His potential reward, if XLU shares rise 2.7% to $54, is $69. You can find that by taking the difference in strike prices between the two options ($54 -$53 = $1) and subtracting the cost of the trade ($1 – $0.31 = $0.69)… then multiplying by 100 shares ($0.69 x 100 = $69).

So, if XLU bounces back to its former path before PG&E’s public and financial collapse, it should easily trade above $54. In that event, that $69 represents a 122.6% return on the amount at risk… the $31 to enter the trade.

This is one of the best risk-rewards we’ve found in quite a while. But that’s what comes of a confused Wall Street misperceiving risks… they come with rewards.

— The Option Specialist

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About the Author: The Option Specialist