A Few Ways to Look at XLC Lotto Calls

Here are a couple conservative ways to price an XLC rally.

First, I'm assuming a rally for these purposes. If the market goes down, XLC is right at support and will sink into the abyss. This is a high-risk trade, but one that I believe has substantial upside in a rally.

Second, I'm not assuming a major market rally. If you assume a major market rally, there are two ways to look at XLC. One is as a QQQ proxy. Both have fallen almost the same amount this year. Another is that XLC fell about one-third more going back to October. If stocks such as Meta and Netflix snap back harder on a rally, then XLC should outperform in a rally. I'm totally ignoring these scenarios, but if those happen, then XLC OTM calls are cheap.

One potential target for XLC is the higher gap. That is about a 6.7 percent gain. Not very interesting to me as an options trade. There is not much of a rally coming to the market if this plays out. Better to be shorting the rips if this scenario happens.

Two, the most recent range. This one can get interesting with July $58 strikes selling for 45 cents. Those could quadruple if XLC gets into this range, more if the rally is frontloaded and time value gets added on. A rally of this size would correlate with a roughly 10 percent bounce in the broader market, which would also mean new lows are coming next. This would not qualify as a big rally, rather one that will exhaust quickly.

Another view is conservative targets for the top-10 holdings in XLC. If all of those stocks make those moves (the biggest would be 27 percent for Netflix and 16 percent for Meta), and the rest of the portfolio bounced a similar amount, XLC would reach $59.30, an 8.8 percent rise from here.

Put these scenarios together and a move towards $60 seems likely to me if the market rallies to any degree.

Smaller rallies are compelling options trades only if frontloaded because time value would remain high. Shorter rallies should be frontloaded because they shouldn't last long, so as long as a moderately bullish move or better is the dominant assumption, there are interesting trades available. If the market moves sideways for awhile, short-term options will collapse in value and return nothing even if the forecast ultimately plays out into August.

Big Bucks, No Whammies

The most compelling trade comes if there's a big market rally now instead of later. I've discussed how this scenario might play out: oil tanks, bonds rally, the Fed shifts dovish to whatever degree. That scenario could take XLC up to the resistance line that still sits around $68 in early August. That's a 25 percent rally, not an outlandish gain in a major bear market rally. In that case, further OTM strikes can still be had cheap and offer 10x or more returns today.

The August calls become interesting in an extended rally because earnings season will be in late July. Who knows what happens then, but Meta and Netflix both have gaps way higher. I can't imagine what might take them towards those areas, but if by some chance there was something positive or simply less-bad amid a general rally, it would give a huge tailwind to XLC. For example, Meta has a gap at $244.65, call it $245. Price of Meta is $159, XLC $54.70. Meta is 17.7 percent of XLC. If Meta hit that level, that move alone with all other stocks held unchanged would take XLC to $59.90.

Another point on options: VIX is low. Many people have discussed this and most traders I've seen comment have complained about it, but it's actually a gift for directional options traders (buying puts or calls outright) because premiums do not reflect potential price moves.

Having said all this, options are highly risky trades. The most common result of buying puts and calls near or out-of-the-money is a 100 percent loss if held into expiry. I don't mind 100 percent losses if I can make 1000 percent or more returns at least one-out-of-ten times.

In conclusion, I think XBI and IBB are the higher probability trades, They offer great potential returns via options or leveraged ETFs, or via individual holdings with strong rebound potential. The cheap calls here were ones I picked up last week, such as $120 strike IBB calls for 45 cents and $121 calls for 35 cents. Traders should exercise increasing caution as prices rise because this is still a bear market.

What makes XLC interesting here is that it hasn't moved yet. It still has outlier potential in a wild, major bear market rally that catches everyone off guard and triggers massive squeezes in annihilated stocks such as Meta and Netflix. If there is any broader market rally underway, even a small one to 10 percent, then XLC will see a big gain soon that will eliminate this window of opportunity because the probability of further gains will collapse as options prices spike. If XLC can rally about 7 percent quickly (5 to 7 trading days), it's possible the July $60 strike could go from around $0.20 today to around $1.00, a 5x gain. I wouldn't touch that strike a week from now because the risk that the rally could soon end would be substantial.

To stress again: XLC is ugly right now.  It didn't positively diverge the way XBI and IBB did last week. Meta made a new low yesterday. It's outperforming the Nasdaq today, but not really considering it should pop in a rally. If I was bearish right now, Meta would be what I'd short because it is going to be at new 52-week lows immediately in a downturn. That makes this XLC trade more of a pure bet on a rally because it's going to take a sentiment shift that traps bears, plus a big rally that has bulls chasing from the sidelines. 

I can't put a hard probability on this, I can only say if you are a high risk speculator, this strikes me as a high enough reward given the potential risk because I believe the market isn't properly pricing in the risk of a bigger rally. If you aren't comfortable with any one of those assumptions, this is not a good trade. On the flip side, if you're bearish on the overall market, a small position in OTM XLC calls would offer great protection from a worst-case rally that catches you mispositioned.