We have been bullish on the energy sector, particularly the oil & gas space. That turned out to be a reasonably decent call in a world where go-go tech stocks hold everyone’s imagination.
But the broad market averages and sector indices prices typically do not go straight up or straight down. (Although we have seen an individual stock behave this way from time to time.) The energy sector has been the high winner so far this year. The question on the inventor’s minds is, “will the trend continue?”
The exhibit above shows the winners so far this year. We are not too surprised the Energy Sector has outperformed. After all, it took a serious beatdown after the financial crisis. The noil and gas companies had a tough time making money for a time there. Most lost money hand over fist. Drivers in NJ were able to fill up for less than $2.00 a gallon for a brief period of time there.
We have watched the sector closely as prices for the SAil & Gas shares are approaching pre-SARS-Cov-19 levels. Carter Braxton Worth shared some interesting charts on Fast Money & Options Action yesterday. One of them is the following of XLE. XLE is an ETF that holds the share of the biggest oil & gas stocks.
XLE is an ETF that holds the share of the most significant oil & gas stocks. Many of them are large integrated companies that explore, produce, refine and market petroleum products. Many of them are large integrated companies that explore, produce, refine and market petroleum products.
Carter points out in the chart above that XLE is bumping up against the point at which the ETF’s price broke down in a big way. He argues that there are owners of XLE who bought the stock over the past 10 years. These investors are now getting back to breakeven or nearly so. He posits that these investors may be inclined to sell as they get back to breakeven. If this is the case, oil & gas stocks’ price is likely to hit a wall or perhaps even fall back.
We have a few positions on the suggested trade list in this sector, and if Carter is correct, they may have gone as far as they will go. We have been contemplating the same thought for over a week now. But we stayed with them since these stocks continued to move higher. We now think it is time to ring the cash register and move on. Could the price of energy stocks continue higher? Sure. Other participants on Fast Money think $100 on XLE is the place to sell. Differences of opinion are what makes a market.
During the year, we suggested a buy-write on USO, the oil ETF. This trade expires this month, and there is no more money left to squeeze out of this one.
Also, we suggested selling a put spread on XOP, the ETF that tracks E&P stocks. This trade expires next month. Even though it is way out-of-the-money, it still has some time value left in it as the options are priced with an implied volatility of around 47%. Assuming a random walk, a 17% chance that the profit indicated turns to a loss. This probability is quite low. Some traders may want to let this one ride and (hopefully) expire worthless, pocketing an additional $71 per structure. We chose to move along.
Finally, there are Energy Transfer Partners. This trade also expires in April and is out of the money. The volatility on this stock is lower than the other two stocks, and it should be. Its transports oil and transports and processes natural gas. This business has a more steady cash flow than the other two, and it does not depend on the price of oil and gas to drive profitability. If we assume a random walk, there is a 40% chance that the current profit turns to a loss. If you are comfortable with that risk, there is another $30 left in the trade per structure. We are not.
Markets are getting more volatile these days. Higher interest rates may put the kibosh on higher prices, at least for the time being. Given the potential for a turn, we think it is wise to take profits and look for other opportunities.
But what if you think Carter is on to something and a selloff is dead ahead. How could one position themselves to capitalize on his thesis? Mike suggested buying a calendar put spread. In a calendar put spread, one buys a long-dated put and sells a short-dated put with the same strike price to help pay for it. One picks a strike price at the level expect the share price to be at the expiration of the short-dated option. Mikes suggested a June/April, $50 strike put calendar. The following is an update of that trade structure he discussed on the show using Friday’s closing price of $52.95.
This trade will cost $136.00 upfront, and this is all one can lose if the position is closed at the April expiration. If the shares trade down to the strike price at expiration, own will make about $179.03. The exact profit will differ because it will depend on the price of the long-dated put at the April expiration.
The beauty of the calendar spread is that it can be bullish, bearish, or neutral, depending on the strike used. Assume you were looking for a more significant selloff. One would use a lower strike. The following is an example of the payoff suing a $46.00 strike on the two puts.
This structure will cost $33 less at $103. If the share price falls to $46 at the April expiration, one makes about $8 more. What do you give up for this lower commitment and, therefore, lower capital put at risk? One breaks even if the share price goes nowhere. In the trade structure Mike discussed on air, one makes about $58.
What if you thought the stock price would go nowhere? Then use an at the money or $53 strike. With this structure, one maximizes their return if the share price closes trading at $53 at the April options expiration date. One could expect to make about $193 in this scenario. It is worth noting that one has the opportunity to make more by selling another short-dated put.
The calendar structure, using either puts or calls, is a strategy for all seasons. It’s appropriate for bullish, bearish, or neutral situations depending on the strike price used. But one has to be aware that the trade needs management at the expiration of the shorter-dated option. What one ultimately adjusts the trade depends on where the share price is trading and if one’s thesis has changed. One can keep a calendar by selling another short-dated option with the same strike price. Alternatively, they can turn it to a diagonal or vertical spread by using a different strike price. Or one can close it out or let the long-dated option ride.
We like to remind our readers that investing involves risk and that it is possible for one to lose most or all their investment when trading options (or any investment for that matter). Be sure to trade within the limits of your capital. Limit your trades’ size to an amount that will not harm you should they result in a loss.
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