Utilities Are Hot. How to Jump In Without Getting Burned.
This is a story about something that isn’t supposed to happen in the stock market.
The utility sector, renowned for its stodgy performance, high dividend yields, and intense regulation, is outperforming the S&P 500, which houses the world’s most admired companies. Nvidia, Meta Platforms, Amazon.com, Apple, and other top technology companies dominate the benchmark index.
The Utilities Select Sector SPDR exchange-traded fund (ticker: XLU) is up almost 14% this year, compared with about 11% for the S&P 500. Some XLU components are operating at an even more feverish pace. NextEra Energy, which is based in Florida, is up almost 28% this year.
The relationship between the two proxies over the past year is more typical, though: The utility ETF is up 13%, compared with a 31% gain for the stock index.
But the future, not the past, is how we invest. The price divergence in the utility sector should prompt investors to reconsider their traditional view of utility stocks.
Some investors were early to recognize the role that utility stocks play in the nascent artificial-intelligence phenomenon. Others would do well to consider an options strategy that monetizes some of the fear and greed of the latecomers.
Computers that operate AI semiconductor chips use a lot of electrical power, creating intense demand for data centers. Conversations with data-center executives suggest that only a few states currently have enough utility system capacity to address AI-power demands. That makes picking specific utilities a challenge.
For that reason—and because the Utility 2.0 phenomenon is so fresh and so hot—investors interested in the theme might well be better served renting utility exposure via options than buying hot stocks that could revert to their usual behavior.
The traditional stock rental strategy is buying bullish call options. Should the stock price increase, the call follows. The allure is that calls cost a lot less than stocks.
When investors are willing to own the underlying stock—and utilities are worthy income stocks—there’s another approach: selling put options and buying calls. This so-called risk reversal—selling a put and buying a call with a higher strike price but similar expiration—monetizes the fear of a pullback and uses that to defray or entirely pay for the hope of an advance.
With the Utilities ETF at $71.44, sell the January $67 put and buy the January $74 call for about $1. The Jan. 25 expiration positions investors to buy XLU at $67 and to participate in gains above $75 (strike price plus the cost of position).
If the trade works, the call is worth $6 should the ETF trade to a new high of $80 by January’s expiration. During the past 52 weeks, it has ranged from $54.77 to $72.91.
If the ETF is below the put strike at expiration, investors must buy the shares or adjust the put to avoid assignment.
The XLU trade expresses a belief that utility management teams will use coming earnings reports to highlight and hype how their companies are linchpins in the AI revolution.
Since prices and liquidity aren’t great for XLU’s distant expirations, investors should use limit orders to pick their buy and sell prices to avoid being steamrolled by dealers who will otherwise execute orders at the obscenely wide bid and ask spread.
Investors need time to fine-tune their utility sector view. By January, the studs and duds will likely have been identified. The trade outlined above is a good wager until that time.