The jury is still out on whether the collapse in oil prices that started in mid 2014 has actually had a net benefit to the global economy as it’s still possible the crash preceded what could be a global recession. Obviously there are those industries that have benefited from lower fuel costs, as it is a major input cost, but much of the savings have been offset by the adverse affects of the U.S. dollar on overseas sales, and soft demand from emerging markets.
The correlation between crude oil prices and airline stocks was fairly evident as the commodity crashed into year end, closing at the dead lows of 2014:
while most airline stocks closed at 52 week and multi year highs (NYSE Airline Index):
From the charts above you can see that Crude Oil ultimately had a huge bounce starting in mid March 2015, before failing in July and making a new low in August. During that same time period though, airline stocks were making a series of lower highs and lower lows, and the correlation to crude oil became less and less throughout the late spring and summer.
It’s my view that the airline industry could be properly screwed no matter what crude oil does between now and year end. Why? If Crude goes higher for the wrong reasons (think not a reflation in global growth or increased demand, but supply issues) then that’s a headwind for airlines. But if crude stays here or goes lower it will because (in my opinion) the global economy is trapped in a deflationary cycle and emerging markets will be exporting their deflation to our shores. This will keep the dollar bid, and that’s a nasty combination for airlines. I see little upside either way.
I want to focus on U.S. carriers that have the most exposure to international routes, and tops on that list is United Airlines which got only 58% of their total 2014 sales from domestic routes vs Delta Airlines (DAL) and American Airlines (AAL) both at 67%. Additionally, UAL is embroiled in a little scandal. Their CEO recently resigned, opening the cabin door for even more uncertainty.
Taking a quick look at UAL’s 2 year chart, $50 is a fairly important long term technical support level. It may also be a magnet for the stock in the coming months:
[caption id="attachment_57106" align="aligncenter" width="600"]
UAL 2yr chart from Bloomberg[/caption]
Short dated options prices, while not cheap at about 42% implied volatility (for 30 day at the money), are still well below the recent spike in August, and nearly 50% lower than the highs reached during last Fall’s ebola scare:
[caption id="attachment_57107" align="aligncenter" width="600"]
UAL 1yr chart from Bloomberg[/caption]
In the current volatility environment, with so much economic uncertainty, I suppose I would much rather be long options premium in a sector like airlines than short it.
It’s a fairly tough entry with the stock down 10% since last Thursday, So I think it makes sense to sell short dated out of the money put options to finance the purchase of longer dated puts.
Trade: UAL ($56.40) Buy the Oct 52.5/ Nov 55 put diagonal calendar for $2.25
- Sell 1 Oct 52.5 put at .80
- Buy 1 Nov 55 put for 3.05
Breakevens on October expiration:
-Max profit at 52.50 with gains lower and losses higher than where stock is now. Gains trail off below 52.50 before October expiration. Once October expires you’re left with a financed November put for earnings that can be turned into a put vertical.
Rationale – We want to finance the near the money put in November that catches earnings by selling a lower strike in October. The vertical nature of the calendar spread means more short deltas to start (-20 deltas) therefore it is more of a bearish bet than the more neutral nature of a straight 55 strike calendar. This trade does best with a slow creep towards 52.50 in the next few weeks.