In mid June when ISIS terrorists were making steady advances on Iraq’s northwest (where much of the their oil production sits) crude oil broke-out to new nine month highs. At the time we highlighted the price action, but detailed a trade (below) that essentially sold the “fear” as we expected the quick spike to see a bit of a reversion. Since then crude is down almost 12%, despite what appears to be an intensifying geopolitical mess, and I am obviously not only talking about ISIS in Iraq, but the failure of the cease fire this week in Gaza, and what Ukraine is calling an “invasion” by Russia of their sovereignty. In today’s MorningWord (A Game of Risk) I detailed my thoughts on the current state of geopolitics, and my conclusion that it is as nasty as it has been in a very long time, and that there seems to be few risk assets pricing any sort of escalation despite no shortage of potential catalysts to spiral out of control.
Just as I wanted to fade the fear back in mid June as it relates to risk assets like Oil, I am now more inclined to buy the complacency as it seems that with the VIX at one month lows (below 12) and the SPX a fraction of a % from all time highs the markets are discounting any economic disruption.
Using the USO as a proxy for oil I now want to make a contrarian play that we see higher prices in the coming months, despite what many oil experts suggest is an oversupply as we head into a seasonally soft period. The consensus is that oil will go lower. The view seems a tad too complacent for me.
I am not interested in merely taking a flier on a commodity that I don’t have a strong command over, but I am inclined to create an options trade that creates a fairly wide band in which I would get long on the upside and the downside with no premium outlay. So here is the trade:
TRADE: USO ($34.85) Buy the Jan15 33/37 Risk Reversal for Even Money
-Sell to Open 1 Jan15 33 Put at .75
-Buy to Open 1 Jan15 37 Call for .75
Break-Even on Jan15 expiration:
Profits: above 37, up 6% make money
Losses: below 33, down 5% lose money
Neutral: Between 33 and 37 on Jan15 expiration no losses
-As the stock rises towards the long call strike the structure should gain in value and as the stock declines towards the short put strike the structure should lose in value on a mark to market basis.
Rationale: This is a structure that plays for a sharp bounce higher in the ETF but gives decent room on the downside (as far as a breakeven on expiration) in case international events subside and the demand concerns that have been hitting oil lately prove to be correct. This structure has a fairly wide range if the ETF trades within a range with no harm no foul. However, if things get heated and oil supply is disrupted, this structure is there for any spike with unlimited upside.
From a technical perspective, the one year chart below shows the break-even on the downside very near the 52 week low, while the break-even on the upside is at the break-down level from late July, which also happens to be 6.5% below the 9 month highs made in June:
Original Post June 13, 2014: Name That Trade $USO: Crude Realities
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:
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: