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Educational Article

Spreading Relative Strength

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Over the past 2 weeks we've been looking at the Dow Jones US Home Construction index ($DJUSHB) and comparing it to the broader market in an attempt to learn about Relative Strength (RS). Once we identified the DJUSHB as a potential source of weakness, we dug into some of the components, looking for which stocks within that sector might be the weakest, and therefore make for an attractive bearish trade. After much discussion and charting, I came to the conclusion that of the four stocks we looked at, RYL was likely the weakest and either CTX or PHM looked to be the strongest (not good for a bearish trade).

If you're just joining us and interested in the prior analysis, you can access the articles using the links below:

And Now For Something Completely Different
And The Verdict Is...

In the week since the last article, price action is confirming that RYL is indeed the weakest of the bunch, and CTX seems to be moving into the lead in terms of being the strongest of the bunch. During our last discussion, I briefly mentioned how we can put on a spread to 'hedge our bets' with a bearish bias on the Housing sector. We want exposure to the downside, but don't want to get clobbered by a rebound in the entire sector. Things like that can happen in a market that tends to be so news driven, especially when the news (Housing Starts, Building Permits, etc.) can be so volatile. The DJUSHB seems to be building an nice downtrend now, and I like the fact that resistance is building in the 300 area, a former level of support.

The way we can put on a hedged position is by initiating a bullish position on the strong stock in the sector, and a bearish trade on the weak stock in the sector. That way, if the sector sees a strong rebound, we have exposure through a bullish position in the strongest stock in the group, which we can expect will outperform to the upside. But if our bearish thesis is correct, we have that bearish position on the weakling, which should outperform to the downside. While it certainly isn't a foolproof strategy, it definitely has merit. While we've already determined our bullish and bearish candidates, there is one final RS comparison I like to do before actually making the decision to put on the trade, and that is a direct comparison between the two stocks in question.

Relative Strength Chart of RYL vs. CTX

Looking at this direct comparison of the two stocks in question confirms the relative weakness of RYL, and today's breakdown below support tells us that the basis for our bias still makes sense. So let's go straight to the option chains and put together a Relative Strength spread. For the sake of simplicity, we want to put the trade on using options as close as possible to ATM (At the Money).

CTX is currently trading at $46.26, so we want to use the $45 Call. Since we're already well into the December expiration cycle, my preference would be to use options with a January expiration, giving the trade some time to work without time decay becoming a significant factor over the near term. The JAN-03 $45 Call (CTX-AI) is currently trading for $4.80, making the cost of this side of the spread $480 per contract.

RYL is still tooling around the $36 level, with Wednesday's close at $36.55. Fortunately, RYL has $2.50 strikes available, allowing us to use the $37.50 put. That JAN-03 $37 Put (RYL-MU) is trading for $3.60 for a cost of $360 per contract. So putting on this spread as of Wednesday's closing prices would cost $840 and give us exposure to movement in the Housing sector over the next 8 weeks. The thing to keep in mind with this trade is that it is entirely possible that both sides of the spread could be profitable. That would happen if RYL broke down further, and CTX found its legs and headed back up the chart. It's certainly not a guarantee, but the research we've done up to this point shows that it is a definite possibility.

Of course, we have the potential that the trade goes against us as well, and we have to take protective action (read: stop losses) to keep that risk under control. We could implement a stop loss (although it would have to be a mental one) on the entire position, where we would exit the entire position if its value dropped by more than 25-30%. Alternatively, we could place an individual stop on each leg of the spread, where we could end up exiting only one side of the spread or the other, depending on the price action of each of the two stocks. This is a highly individual issue, but if implementing this trade myself, I would place a resting stop individually on each leg of the spread.

The other risk that we need to consider when putting on this type of trade is the possibility of a large change in volatility. If volatility declines substantially, then we could see both sides of this trade move against us, even without adverse price moves in the underlying securities. With the VIX finally breaking back into its historical range, and the initial cost of entering this trade, I would definitely consider this a significant risk. So how do we mitigate this risk? Spreads. One of the great advantages of simple bull and bear spreads is that in addition to reducing the cost of entry, they help to insulate us from the effects of changing volatility.

So how would this RS spread strategy change if we were to utilize a standard spread strategy? Spread traders are probably way ahead of me already, but I'm going to provide a bit more detail for those that are less familiar with spreads.

Rather than just buy the call on CTX, we want to put on a Bull Call spread by simultaneously buying the $45 call and sell a call at a higher strike. In this case, I'd select the $50 strike, currently trading for $2.25. So doing the math, the bullish side of our RS spread would only cost $2.55 ($4.80-2.25). By putting on the spread, we are cutting our risk on the bullish side of the trade by almost 50%, but the price we pay for that reduction of risk is that our upside is also limited. The maximum return at expiration would be $2.45 ($5.00-$2.55), while we are still risking $2.55. Normally that isn't great on a risk/reward basis.

Looking at the bearish side of the RS spread, we would supplement our purchase of the $37 RYL put by selling a lower strike put with the same expiration. My preference would be for the $32 put (RYL-MZ), currently trading for $1.60. That reduces the cost of the bearish side of the RS spread from $3.60 to $2.00. Maximum return on this side of the spread is limited to $3.00 ($5.00-2.00), while the risk has been lowered to $2.00.

I'm not wild about the risk/return about using the Bull Call and Bear Put spreads in place of just buying a call and buying a put. But there are lots of possible permutations we could employ to improve our odds. Since we're doing a spread on RYL and a spread on CTX, we've insulated ourselves from the effect of both changes in volatility and time decay. That means we could consider using December contracts rather than January. That would reduce our cost of entering the spreads, while keeping the potential reward unchanged. That improves the risk to reward ratio.

Sophisticated spread traders could really have fun with this RS Spread strategy, putting on a Bear Call spread (Buy the high strike and sell the low strike) on RYL and a Bull Put spread (Buy the low strike and sell the high strike) on CTX. This strategy allows us to take in a credit on each side of the RS Spread, and we get to keep those credits, so long as both of the sold options expire out of the money.

My intent here isn't to provide what I think is a money-making trade. What I wanted to accomplish is show a creative way in which trades can be crafted to take advantage of relative strength where we find it. The details of the RS example we've gone through in the housing sector are unimportant. If you understand the process, then you know you can do this with any sector in the market or any group of stocks you choose. Finding the disparity in Relative Strength is the technical analysis part of the process. Then that knowledge can be put to use, using the strategy of your choice, whether that involves a sophisticated spread strategy or simply going long the strong and shorting the weak. Knowledge is power. Hopefully this little exercise has you feeling invincible.

Have a great week!

Mark



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