New Trade – $XLE: Energy Transfer

by Dan October 3, 2014 2:15 pm • Commentary

Earlier (below), I laid out a bullish thesis on Chevron (CVX), but I wanted to add a trade idea that looks attractive in the Energy Select etf (XLE) for those who share a contrarian bullish view for oil stocks between now and the start of 2015. One of the reasons I am looking at the XLE is because of a what I think is a fairly unique set up, where the aggregated etf has a higher implied vol than both of its largest components, on both a relative and absolute basis.

Here is a list of the top 5 holdings of the XLE, which make up 44% of the etf weight:

From Bloomberg
From Bloomberg

CVX at-the-money options looking about 30 days out trade at a 18.4 vol, while Exxon (XOM) trades at about 17.4 vol.  Interestingly XLE trades at a 20.5 vol, and has gone from 52 week lows to 52 week highs in a month:

XLE 1yr chart of 30 day at the money IV from Bloomberg
XLE 1yr chart of 30 day at the money IV from Bloomberg

It makes sense that an individual stock would have higher implied vol than a basket of stocks as the single name has greater idiosyncratic risk. Meaning one headline could send the stock up or down in a dramatic fashion where that one headline would have much less impact on the etf of which the stock was a component.

This set up looks interesting for the same reason that the CVX trade does, but in some ways has less risk, but possibly less reward so we are going to look at a different trade structure that should benefit from a vol crush on a bounce in the underlying.

After doing a little research into this trade, I noticed that there is another market participant who shares this view, as they bought the Oct 31st weekly 92/95 1×2 call spread 10,000 by 20,000 for 27 cents.  This trade breaks-even at 92.27, with a max gain of 2.73 at 95.  The payout trails off btwn 95 and 97.73 with losses above that.   I like this trade but I don’t think it is suitable for retail investors given the uncovered risk to the upside, and I think $95 maybe a tad aggressive of a target between now and the end of the month.

A call butterfly is a good alternative to a 1×2 call spread, with similar risk/reward:

TRADE:  XLE ($88.30) Bought the Nov 87 /92 / 97 Call Butterfly for $1.50

-Bought to Open 1 Nov 87 Call for 3.60

-Sold to Open 2 Nov 92 Calls at 1.15 each or 2.30

-Bought to Open 1 Nov 97 Call for .20

Break-Even on Nov Expiration:

Profits: gains of up to 3.50 between 88.50 and 95.50, max again of 3.50 at 92

Loses: Between 88.50 and 87 lose up to 1.50, between 95.50 and 97 lose up to 1.50 with max loss of 1.50 below 87 and above 97

Rationale:  This trade is short volatility in XLE on any bounce from here, which allows for participation in both some incremental upside (up to 5%) as well as a move lower in implied volatility from the recent highs.  The trade will take some time to make money, so it’s not a pure delta trade like in CVX, but it has time on its side if XLE remains stagnant over the next month.



Previous Post Oct. 3rd 2014:  New Trade – $CVX: Oil Change

Despite no shortage of geopolitical headlines that could cause supply shocks in the crude oil market, the price of the commodity has seen a precipitous drop (down about 16%) from the 52 week highs made in mid June to new 52 week lows this week:

Crude Oil Futures 1yr chart from Bloomberg
Crude Oil Futures 1yr chart from Bloomberg

Back In late August, we initiated a bullish trade in USO that defined a wide range between now and January expiration where we would gain long exposure in to the etf that tracks the price of WTI Crude oil (read here).  Since we placed the trade, the etf is down 3%, the commodity is down about 4% and our trade is down about 1.5% of the underlying etf.  We are keeping a close eye on the position, but we think the set up is not horrible given the increasingly oversold nature of the sector and what seems to be a growing consensus of lower oil.

While it takes a much savvier macro soul than I to figure out the money flows in and out of some of the most economically sensitive risk assets on the planet, the stocks of the companies that refine the raw material are another scenario all together.

For instance, Chevron’s (CVX) shares have declined about 12% from the all time highs made in late July, now approaching a fairly oversold technical condition:

CVX 2yr chart from Bloomberg
CVX 2yr chart from Bloomberg

For the better part of the last 2 years, CVX has traded above $115, with the March 2014 low looking like a sort of dream entry level on the long side.

With the stock’s persistent decline, implied volatility (the price of options) has risen from a matched multi-year low in late August to a yearly high just this week:

CVX 30 day implied volatility, courtesy of Bloomberg
CVX 30 day implied volatility, courtesy of Bloomberg

For those looking to play for a rebound in CVX shares using the elevated levels of implied volatility to finance the purchase of upside calls is a fairly attractive way to do so.  While $115 looks like a decent level to stick your toe in on the long side, $110 would be the level in the event of a panic that would mark an entire round-trip from the 52 week lows to the all time highs and back.  This is the level that we want to make sort of line in the sand for the trade under what we would define as a high probability long from that level.

So here is the trade:

TRADE:  CVX ($117.75) Bought Jan15 110 / 120 Risk Reversal for 0.95

-Sold to Open 1 CVX Jan15 110 put at 2.05

-Bought to Open 1 CVX Jan15 120 call for 2.95

Break-Even on Jan15 Expiration:

Profits: 1 for 1 with the stock above 120.95

Loses: Between 110 and 120, lose 0.95; between 120 and 120.95, lose up to 0.95; below 110, lose dollar for dollar with stock plus the 0.95

Rationale:  CVX has traded above $110 since late 2012, and trades at a discounted valuation relative to its largest peer, XOM (a slight discount on P/E, a larger discount on a EV/EBITDA basis).  The stock is quite cheap vs. the broader market as well.  The risk reversal is a much lower risk way to get long CVX here rather than simply buy the stock.