What XLU Options Traders Can Tell Us About Red-Hot Bond Yields

Utility ETF XLU is testing a key long-term trendline

Subscribers to Chart of the Week received this commentary on Sunday, October 8.

The playbook is simple at this point, but when will the defense start to catch on? Reports of encouraging economic conditions – like upbeat jobless claims on Thursday — result in a spike in bond yields and a selloff in stocks. Unfavorable economic conditions, like the ho-hum September consumer price index (CPI) that showed slow growth two weeks ago, were cheered with broad market gains. What’s up is down and what’s down is up, all while the investor is forced to adjust on the fly to this volatile roller coaster.

No sector was hit as hard by this three month bout of stock market volatility as the Utilities Select Sector SPDR Fund (XLU). As the 10-year Treasury yield reached 2008 financial crisis levels, XLU pulled back to pandemic-era lows. Is this a buying opportunity staring investors in the face, or indicative of a larger Wall Street trend? The answer, as it often tends to be, can be found in options trading trends.

But first, some context for just how truly egregious a week it was for XLU. The exchange-traded fund (ETF) has now logged three straight weekly losses and ended September with its worst performance since March 2020. A new month offered no reprieve; on Tuesday, Oct. 2, XLU suffered its largest downturn since April 2020.

Why this sudden drawdown, when market participants usually hide out in a defensive staple amid rampant stock market volatility? Money market funds yielding over 5%, or similar short-term vehicles offering risk-free returns look an awfully lot better right now in a high interest rate environment like the one we find ourselves currently in. Bond yields breaking out was only the fuel to the fire.

The utilities ETF has now racked up a 20% year-to-date deficit, with most of that damage occurring in the last six months. KeyBanc chimed in on utilities on Thursday, as part of a bear note on sector staple NextEra Energy Inc (NYSE:NEE) – ironically an October outperformer, historically. The analyst in coverage noted that this selloff “has created sufficient valuation dislocations that investors can benefit from.”

XLU Selloff COTW

Perhaps KeyBanc is eyeing the same long-term XLU chart that flashed across our terminals this week. Per the chart below curated by Schaeffer’s Senior V.P. of Research Todd Salamone, this selloff has XLU testing its 120-unit monthly trendline, or 10-year moving average. Beyond the irony that the 10-year trendline is stepping up for XLU as the 10-year Treasury yield skyrockets, note that this moving average stepped up as support in 2011 and 2020 troughs.

XLU Trendline COTW

How are options traders reacting? By pounding calls into oblivion. Combined data from the International Securities Exchange (ISE), Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX) shows XLU with a 10-day call/put volume ratio of 5.27, that arrives in the 100th annual percentile, confirming a much stronger-than-usual slant toward calls over puts in the last two weeks. On Monday, XLU options’ volume was 3.4 times the average intraday amount, with a whopping 202,000 contracts changing hands and a relatively split bias and puts holding a slight advantage. A notable trade in that cluster was the March 2024 strangle at the 55 and 60 strikes, with a volume-weighted average price (VWAP) of $4.05.

On Friday, bond yields spiked again after another red-hot jobs report. XLU promptly shed 2.5% out of the gate, but appears to be settling around $55, right around where those options traders pulled the trigger for that March strangle. With long-term support in place, maybe these XLU options traders are telling us something about Treasury yields.

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