About a week and half ago we thought XOM was getting a bit oversold and fairly uncharacteristically made a bullish play (below) by financing out of the money calls by selling an out of the money puts and getting what we call a Bullish Risk Reversal on for no cost. Since the time of the trade XOM has rallied about 4% and the trade has registered a nice short term profit. At this point we want to risk manage the trade and take off the naked put that has lost almost 3/4’s of its original value and now makes little sense to remain short given the low probability but high risk potential. We also considered spreading the long call, but at this point we like the idea of booking the short term gains and taking another look at the stock if it were to settle in back towards $90 again.
Action: XOM ($93.40) Sell to Close April 85/92.50 Risk Reversal at 2.45 for a 2.45 gain
-Buy to close XOM April 85 Put for .40
-Sell to close XOM April 92.50 Call at 2.85 to close
Original Post Feb 4th, 2014: Adult Swim Trade – $XOM: Exxon, Exxoff
Back in late November, we thought the rally in XOM from the 52 week lows, to new 52 week highs in a bout 6 weeks was largely the result of Berkshire Hathaway’s accumulation of a large stake in the company. At the time we wanted to fade that price action, targeting a re-tracement back to the $90 midpoint of the range. With the stock now down at our intended target from Jan expiration, the trade was obviously a mis-fire by a couple weeks, but we think it is worth revisiting after such an extreme sell off from new all time highs made in late December.
The one year chart below shows the almost 20% move from the 52 week lows made in October to the all time highs made in late December, a fairly aggressive move for one of the top 3 market cap companies in the world. With the stock just below support at $90, I think it is safe to say it is at a very significant near term technical level.
It doesn’t take much of a chartist to see that $85 is MASSIVE support on the downside, and $95 should serve as healthy resistance on the upside.
From a volatility standpoint, 30 day at the money implied vol (IV) is approaching the highs of the last 12 months, simply meaning that the prices of options are relatively high in the stock:
This morning there was a bullish roll in July calls where a trader sold 24,000 July 105 calls at .28 to close and bought 12,000 July 97.50 calls for 1.26 to open. While this is not exactly a massive bet from a premium stand point, it is likely an investor adding some leverage to an existing long position in the event of move back towards the prior highs.
For those who think the near term sell off is getting a bit overdone, but also think that an ideal entry on the long side would be $85, it would be our suggestion to use elevated IV to create a long structure.
Adult Swim Trade: XOM ($89.70) Buy Apr 85/ 92.50 Risk Reversal for even $
-Sell 1 Apr 85 Put at 1.45
-Buy 1 Apr 92.50 Call for 1.45
Break-Even on April Expiration:
Profits: above 92.50 profits unlimited
Losses: no losses btwn 92.50 and 85, but worse case scenario, the stock is below 85 on April expiration nd you are put the stock and suffer losses.
Rationale: The $85 level is a massive support level for XOM over the past 18 months. The stock held that level on multiple occasions in 2013. This risk reversal structure only gives you downside in the stock below $85, while offering upside above $92.5, which is where most of the price action has taken place since the news of the Berkshire stake. The risk/reward asymmetry is also partly due to the skew in XOM options, where downside implied volatility is higher than upside implied volatility.
We labeled the trade “Adult Swim” as it is important that readers understand the risks of being short puts, the margin requirements and size trades similar to this appropriately.