$XOP Tick

by Dan June 24, 2016 12:42 pm • Commentary• Trade Ideas

The financial world is picking up the pieces of yesterday’s Brexit vote. The price action in most major risk assets, shows just how much the Leave vote caught market participants off-sides.

While it is still not clear if or how the UK will actually leave the EU, this type of uncertainty probably keep global financial markets on edge for the balance of the year with any periods of calmness just one headline away from another spike of volatility. The bigger issue is that sort of uncertainty and volatility could be the final push for a global economy that has been on the precipice of a recession for years:

While even I as caught somewhat off guard on the Leave vote, and did not expect today’s action, it fairly well fits into my broader investment thesis (read here from this am: “This is not a moment, it’s the movement”).  So the knee-jerk reaction of lower stocks, higher dollar vs Euro, Pound, Yen etc, higher U.S. Treasuries & Gold all make sense in the investment landscape we have been in, and what is now an increasingly more difficult one.

The rip in the dollar makes sense despite the bounce in Treasuries today, this is beyond the Fed’s control and clearly not what they had expected when the FOMC raised the Fed Funds rate last December for the first time in 9 years. But the fact of the matter is the risk of global recession has increased in the last 24 hours, and what comes next is likely a flight to quality… and that means a bid to US Dollar & US Treasuries.  US stocks are a bit trickier as large cap multinationals with lots of exposure overseas will face headwinds of the strong dollar, and smaller cap domestically focused stocks could face the headwind of tightening credit conditions and a reversal of ytd gains in sectors like energy and materials.

If this is correct, I suspect Oil (and related stocks) sells off for a few reasons. First, dollar strength. Second, the potential for weaker global oil demand. And third, ultimately those smaller cap names see a return of fears about defaults/bankruptcies etc.

I want to avoid the XLE, the Energy Select etf, which 40% of its weight is in Exxon (XOM), Chevron (CVX) and Schlumberger (SLB) that have dividend yields between 2.55% and 4.15%, which might keep them bid relative to their smaller cap brethren.

So I want to focus on XOP, the S&P Oil & Gas etf. No single holding makes up more than 2.5%, and the top 20 holdings average about 2% each.

Short dated options prices in the XOP are well below their February highs, with 30 day at the money implied volatility at 38% (the price of options, while realized volatility (how much the underlying is moving) is just off of 2016 and 10 month lows, which could signal complacency:

XOP 1yr chart of 30 day implied vo (blue) vs 30 day realized vol (white) from Bloomberg
XOP 1yr chart of 30 day implied vo (blue) vs 30 day realized vol (white) from Bloomberg

The technical set up in XOP looks poor. I just saw a rejection below $40 and is below the uptrend that had been in place from its February lows:

XOP 1yr chart from Bloomberg
XOP 1yr chart from Bloomberg

So what’s the trade?  

*XOP (34.70) Buy the September 34/28 put spread for 1.70
  • Buy 1 Sept 34 put for 2.30
  • Sell 1 Sept 28 put at .60

Break-even on Sept expiration: Losses of up to 1.70 above 32.30 with total loss of 1.70 above 34. Gains of up to 4.30 below 32.30 with max gain of 4.30 at or below 28.

Rationale – This trade is still low vol considering all the moving parts in the global economy this Summer. It fades recent strength in the etf that could easily reverse if we see signs of recession out of Europe and it also takes advantage of  a return to a strong dollar environment.