Mean Reversion Trade Ideas From Najarian

In his guest column for the Striking Price 6th July, Jon Najarian discussed two interesting trade ideas. His claim is that consumer staples and health care return twice what financials return in the third and fourth quarters.

XLP, the Consumer Staples Select SPDR ETF is down 2% this year while Walmart (WMT) is down 14.8% year to date. If you look back one year, XLP is down 11% and WMT is down 13%. Not a big difference and that weakens Najarian’s argument that WMT should bounce back. He recommended a bullish call spread, buying 47.50 September calls and selling 52.50 Sep calls. Expecting back to school spending to raise Walmart shares.

As a Pairs Trade

I calculated that the correlation between XLP and WMT is 69% over the last two years, and 50% over the last ten years. If you believe that WMT has lagged XLP, then you would want to buy Walmart and sell XLP to take out any market swoon in September.   If you were doing this pair trade with stock, you would buy Walmart and sell XLP.  Since Walmart is $48.55 and XLP is $23.75, say, about twice as large, and the correlation is about 70%, one would sell 1.4 times as much XLP as one bought WMT. 

Options are not linear so one wouldn’t keep these rations for say a bear spead in XLP to hedge a bull spread in WMT.  How could you do a hedged trade with options and still capture the back to school trade? I don’t see it. Eventually, when the CBOE puts out volatility options on individual names, it will be possible to hedge the trade.

One way to make the trade higher probability is to buy the bull spread deeper in the money. So instead of buying the 47.5 call and selling 52.5 call for $1.84, you could buy the 45 Sep call and sell the 50 Sep call for $3. The 50 Sep call has a delta of 36 while the 52.5 has a delta of 16.7. So the 50s are twice as likely to be in the money as the 52.5s.

Health Care

Another idea discussed was to buy Cardinal Health (CAH) LEAPs Jan 2010 $20 calls for $11 and sell Aug 30 calls for $2 against them.  If CAH was above $30 on 21 Aug, when the calls expired, you would make $2 / $11 or 18% since the rise in the LEAP would match the amount that the August calls were in the money.  Then he’d buy them back and sell the next month’s calls.  That way he could cover a large fraction of the cost of the LEAPs.