$XLE – Crude Intentions

by Dan March 17, 2016 2:37 pm • Commentary• Trade Ideas

Crude oil and the dollar have been the source of much of global market volatility across asset classes the past year.  The end of QE in late 2014 caused the dollar to emerge from its multi-year, Fed-induced dirt nap. That dollar resulted in the collapse of crude oil.

Today, the US Dollar index (DXY) is having one of its largest one day moves some time, down 1.25% and below $95 for the first time in 2016.  Before we all get too geeked-up about the collapse in the dollar, I think it makes sense to consider that on 5 occasions over the last year the DXY has bounced off of technical support near $93:

DXY 2 year chart from Bloomberg
DXY 2 year chart from Bloomberg

For a whole host of reasons, none more important than the decline in the dollar (DXY down 4% since March 1st), crude oil has rallied 50% from its 13 year lows made in February. I would add that while the rally is eye-popping, and the easing of tensions in credit and equities have certainly helped, there is little by way of decreased supply or increased demand to point to, so in my mind little about it is fundamental. I would also add that on three instances in the last year crude oil has staged massive counter-trend rallies (below, 45% and 35% last year and the existing 53% rally) all have failed at its 200 day moving average, a momentum indicator that crude has not been above since August 2014. The series of lower lows and lower highs should NOT be ignored, and a great short entry might emerge just below $43 at the 200 day mva… if it gets there:

From Bloomberg
From Bloomberg

The idea if stepping in front of a freight train like crude oil’s epic one month bounce off of a more than decade low after a vicious 18 month nearly 80% decline seems fairly silly.  But if it is nothing more than technical, lacking a fundamental shift, then making a contrarian short biased trade with defined risk trade could make a lot of sense. If you don’t trade crude oil futures, which I don’t then you can consider etf’s or etn’s that track the price of crude like USO and OIL, but as we described last week in a post (here), they suck.  Which leaves you with oil stocks or etfs that are composed of them.  On March 3rd we detailed in a post (here), why the XOP, the S&P Oil & Gas etf which is made up of a little more than 100 stocks, with none having more than a 3.5% weight, made more sense to play oil for a bounce than did the far more concentrated XLE, S&P Energy Select etf, where Exxon (XOM), Chevron (CVX) and Schlumberger (SLB) make up 40% of the weight.

Now looking the other way, I prefer the concentration of the big three in the XLE to play for a move lower.  The 5 year chart below of the XLE shows the steady downtrend from the 2014 highs above $100, to its January low of $50:

XLE 5yr chart from Bloomberg
XLE 5yr chart from Bloomberg

The 200 day moving average in the XLE is $65, the etf has not been above that since September 2014, and every counter-trend rally in the etf has failed just below it.  This is as good of spot as any to take a shot on another failure.

Short dated options prices have come in hard from the lows in Jan/Feb and I am hard-pressed to see 30 day at the money implied volatility to far below 20%:

[caption id="attachment_62279" align="aligncenter" width="600"]XLE 1 year chart of 30 day at the money implied vol from Bloomberg XLE 1 year chart of 30 day at the money implied vol from Bloomberg[/caption]

This is the sort of trade that makes sense to give yourself a little time, and pick a strike to be long where you think it has a good shot of going to on a pullback. Generally we don’t love to be this far out of the money, but if the crude were to re-trace a bit of the recent move, $60 could be a magnet in the XLE. So any position needs to target that in the near term in order to play for moves lower longer term. Therefore a put calendar makes sense:

*XLE ($64.22) Buy April/June 60 Put Calendar  for 1.40
  • Sell to open 1 April 60 put at .55
  • Buy to open 1 June 60 put for 1.95

Rationale: The ideal situation in this position is for XLE to pull back to $60 in the next month, without going too far below. If that happens the april put can be closed and either rolled to May to keep the calendar on or rolled into a downside put sale in June, creating a (same month) put spread. The risk is XLE continues higher or even goes sideways as the vol being bought in June is high historically (but down quite a bit from recently).