Sector and industry group analysis can help us determine which pockets of the market are most in favor.
Traditionally-defensive utilities have entered a sustained uptrend. This normally boring area of the market is transforming before our eyes, introducing advancements in energy grid modernization and expansions in infrastructure.
Stocks in this sector are underappreciated, and the marketplace has yet to price in their full potential in the years ahead. When borrowing rates decline, utility stocks become more attractive and also offer the potential for significant price appreciation.
With interest rate cuts from the Fed underway, this pocket of the market is returning to the forefront. A lower interest rate environment makes utility dividends more appealing, increasing demand for their stocks.
The Zacks Rundown
The utility sector is comprised of companies that provide basic amenities such as electricity, natural gas, and water, including those that operate as producers or distributors of power. They are part of the public service infrastructure.
There’s a reason that the Zacks Utilities Sector is ranked #2 out of all 16 sectors in this environment. It’s because more utility stocks are experiencing positive earnings estimate revisions. Because it is ranked in the top half of all Zacks Ranked Sectors, we expect this group to outperform the market over the next 3 to 6 months.
This group is outperforming in 2024 and is the 2nd best-performing S&P 500 sector, trailing only tech:
Image Source: Zacks Investment Research
Stocks in the top 50% of Zacks Ranked Sectors outperform the bottom 50% by a factor of more than 2 to 1. By identifying top-ranked sectors, we can dramatically improve our odds of success.
Option Essentials
Before we analyze today’s trade, let’s review some option fundamentals as a refresher. There is no need to worry about complex mathematical formulas or equations. Over the years I’ve found that the more complicated a strategy is, the less likely it is to work over the long run.
Options are standardized contracts that give the buyer the right – but not the obligation – to buy or sell the underlying stock at a fixed price, which is known as the strike price. A call option gives the buyer the right to buy a particular security, while a put option gives the buyer the right to sell the same.
The investor who purchases an option, whether a put or call, is the option buyer, while the investor who sells a put or call is the seller or writer.
These contracts are valid for a specific period of time which ends on expiration day. There are weekly options, monthly options, and even LEAPS options which are longer-term options that have an expiration date of greater than one year.
Options consist of time value and intrinsic value. In-the-money options consist of both components; at-the-money and out-of-the-money options consist only of time value. At options expiration, options lose all time value.
Below we’re going to explore a call option purchase strategy.
Leverage Your Utility Returns
The Utilities Select Sector SPDR ETF XLU is in a price uptrend and is a good candidate for a call option purchase:
Image Source: StockCharts
When done correctly, trading options provides huge profit opportunities with limited risk.
In today’s trade, we’re going to target the December 20th expiration date and the 65-strike price. Purchasing this option gives us the right, but not the obligation, to buy 100 shares of the XLU ETF at $65 on or before December 20th, which is about 2 months from now.
The table below displays the risk/reward profile for this trade. XLU is currently trading at $81.63 (orange box). We are purchasing 1 December 20 65-strike call at 16.7 points, which is the option premium. Since options account for 100 shares of the underlying stock, the total cost for this call option trade is $1,670 as we can see in the yellow highlighted box.
Image Source: Zacks Investment Research
The top (blue) row shows the performance of the XLU ETF based on different percentage scenarios at expiration. The bottom (purple) row shows the corresponding percentage return for our call option trade. We can see that if XLU remains flat, this trade would encounter a minor loss of 0.4%. If XLU moves up 5%, this trade will realize a 24% profit. If XLU advances 15%, we would realize a 72.9% profit.
This illustration shows the inherent leverage that options provide. A stock investor who bought 100 shares of XLU would have to contribute $8,163, which is a larger investment. A 15% increase in the stock price would yield a $1,224 profit.
On the other hand, in this example the option trader only needs to contribute $1,670 to control the same amount of underlying XLU shares. A 15% move in XLU stock would net a $1,217 option profit – a nearly identical profit amount with only about one-fifth of the investment!
Also note that this option contains relatively little time value. The 0.07 points worth of time value (red box) equate to less than 0.1% of the underlying stock price. A good way to manage risk when buying call options is to minimize time value and maximize intrinsic value, as time value decays rapidly in the days leading up to option expiration.
Bottom Line
With utility stocks experiencing positive earnings estimate revisions, this sector is ranked highly and outperforming the general market. The XLU ETF is in a robust uptrend and provides us with diversification benefits.
A great way to take advantage of this move is via low-risk call options. This allows us to leverage utility stock returns with the power of options. Be sure to keep track of how this pocket of the market performs as we head into the final months of the year.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
