If only on a small scale, this week saw the re-introduction of a little fear in the markets as Iraq is back in the news with the Sunni group ISIS overrunning the Iraqi Army in the northwest of the country and making incursions into where much of the country’s oil production sits.
Oil rallied to new 9 month highs, gold bounced off of 4 month lows, bonds caught a bid, the VIX get a 10% bump off of what felt like all time lows, and SPX sold off ever so slightly. As some pundits blew the dust from the ol’ “risk-off” files, the price movements for the most part were fairly muted. Except for crude oil. The commodity broke through key technical resistance at $105:
It’s hard to knock that sort of price action and it looks like a fairly nice breakout. But if the reason for the new found interest in black gold is the situation in Iraq, then I would suggest this could be a fade-able move. Not because the situation in Iraq doesn’t seem tragic and is likely to get worse before it gets better, but because recent crisis trading history has shown us that if you faded the fear trade over the last couple years it was likely a profitable strategy.
For instance back in mid March, we bought calls in the RSX (read here), the Russian equity etf, when it felt like the situation in Ukraine was hitting a fever pitch.
Here was the 1yr chart of the RSX on March 14th when we faded the fear as images of a brewing civil war in Ukraine was plastered all over the news:
RSX 1yr chart from Bloomberg on March 14, 2014
So, flash forward today and the RSX is up 20% and while the situation is far from resolved and remains dicey, the panic in markets has subsided:
As we think about oil, there’s a chance for a pull back in the next few weeks if the Iraq situation is deemed as not having a material impact on global production. Some would argue that crude prices have more to do with the perception of an improving global economy, but I don’t see that, and the longer oil remains above $100 the greater likelihood that it hurts economic growth.
So we want to make a near term defined risk bearish bet that oil comes in 5-7% or so back to support, BUT NOT YET. We are going to look at the USO, the oil ETF to express this view, possibly early next week. We are not making a long term macro bet as we are not macro traders and have little edge, but from a sentiment and technical standpoint we like the entry. If we are wrong and the situation gets much worse and traders/investors start to reach for oil and we see a meaningful breakout we will quickly cut our losses.
The two year chart of USO shows the etf approaching the prior high from September 2013, we think this is an attractive entry on the short side:
Here is the sort of trade we are looking to put on early next week:
TRADE: USO ($39.20) Buy Aug 38/36 put spread for .45
– Buy 1 Aug 38 put for .65
– Sell 1 Aug 36 put at .20
Break-Even on Aug Expiration:
Profits: between 37.55 and 36 up to 1.45, with max gain of 1.45 at 36
Losses: between 37.55 and 38 lose up to .45, max loss of .45 above 38
Rationale: We are looking at out of the money put spreads as commodities tend to trade fairly technically (read ENIS’s chart of the day post on Oil from earlier here), and a re-tracement and a break of $38 on the downside, could yield a test of the 50 day moving avg at $37.25 and then ultimately the 200 day at $36.
Lest see what this weekends news brings, ideally we would like an entry at or near $40.