XHB - XHB: Remaining Bullish Despite Recent Volatility

2023-10-28 04:45:30 ET

Summary

• SPDR S&P Homebuilders ETF shares have dropped close to $15 over the past eight weeks, but there are signs of a potential bottom.
• Implied volatility in XHB has spiked above 30%, indicating a projected 30% move in any direction over the next 12 months.
• Downside risk may be overrated in the fund due to the strong performance and growth prospects of companies in the building products and homebuilding sectors.

Intro

If we pull up a 12-month chart of SPDR S&P Homebuilders ETF ( XHB ), we see that shares are down close to $15 a share over the past eight weeks. Sustained selling in the ETF has resulted in the fund having lost its 200-day moving average with the bearish trend most likely continuing before a firm bottom is confirmed.

However, two pieces of information on the technical chart demonstrate that the bottom may not be as low as many think at this point in time. Firstly, XHB's volume trend for the most part has not followed the share price down over the past 8 weeks. Volume trends in the main precede share-price action so it is encouraging to see buyers continuing to buy into this latest down move.

Secondly, as we see below, if shares indeed continue their descent, they should find solid underside support just above the $66 level as well as at approximately the $64 level. These support levels should at least put a halt to the aggressive selling we have seen in recent weeks. In fact, for the long-term option strategy, we are about to put forward here, any form of consolidation in XHB will actually help our position over time. Let's get into it.

Implied Volatility Spike

Implied volatility gives investors a picture of the expected move the underlying in question will make over the forthcoming 12 months. As we see below, implied volatility in XHB has spiked above the 30% mark due to the sustained selling we have seen in the ETF, particularly over the past 8 weeks. What this means is that the market currently projects a 30% move (in any direction) from its current price over the next 12 months. What is also noteworthy is the fact that further out cycles also have seen a spike in their implied volatility. This is important to our strategy as we will be initially utilizing the January`2024 cycle which is close to 90 days away.

Risk May Be Overrated

As we see below, XHB's above-average implied volatility and elevated short-interest undoubtedly bring added risk to this play over the near term but we maintain investors need to keep their eyes on the big picture in the homebuilders space.

For example with the fund's weighting being heavily targeted at the building products space (47%) as well as the homebuilding space (34%), we do not foresee any material slowdown at preset from the majors in these industries going forward. Although rising interest rates may be dampening affordability in the near term, investors need to remember that a significant supply shortage remains which in turn is keeping demand buoyant.

For example, we see that XHB's biggest holding ( retailer - Williams-Sonoma, Inc. ( WSM ) continues to grow its margins which in turn is having a positive impact on its forward EPS revisions. Furthermore, on the homebuilding side (PulteGroup, Inc. ( PHM ) margins continue to gain traction where earnings are expected to grow by a healthy 6%+ in this present fiscal year. Suffice it to say, given the trends we are witnessing in both the building products space as well as core homebuilding, we believe downside risk is not as large as XHB's level of short interest may demonstrate. Furthermore, the fund's diversification across 36 companies, extremely strong dividend growth rate, low expense ratio as well and strong liquidity profile are all calling cards to invest in the XHB fund as opposed to an individual company in this space.

Strategy

Therefore, as alluded to earlier, (with shares trading close to the $70 mark) what we are looking at here is the sale of the January'2024 put ratio spread (Purchase of the $70 strike and sale of the $68 strike in a 1 x 2 fashion where sold contracts will always be double the number of purchased contracts in the position). For simplicity purposes, the setup below incorporates the purchase of 1 long put contract ($70 strike) in conjunction with the sale of 2 corresponding ($68 strike) contracts. The benefit of this strategy is the resulting reduced buying power plus more importantly, the lower breakeven which comes in at $64 per share of the fund approximately.

Furthermore, we are using contracts (which are pretty much at the money) in the January 2024 cycle because vega is higher for longer-dated option contracts which are at the money. Therefore, since Vega measures the option's sensitivity to changes in implied volatility, any change in XHB's implied volatility (which is inflated at present) should affect our $68 puts in a favorable way.

Remember, this is a long-term strategy in XHB. If the position goes against us, we have plenty of extrinsic value in those options to keep on rolling our contracts both forward in time and down in price which will consequently lower our breakeven over time. Therefore, make sure once this position is opened, you are committed to taking a long-term stance. We will update both this article & the linked portfolio below in the comments section with any position changes such as profit-taking or rolling strategies to keep followers posted.

Conclusion

Therefore to sum up, although the XHB Homebuilders fund has experienced plenty of volatility over the past two months or so, we believe downside risk is limited due to underlying strength in both the building space as well as the core home-building space. Furthermore, the attractiveness of the fund's dividend & expense ratio should bring in buyers if shares of the fund drop even more. We look forward to continued coverage.

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