Daily Stock Market Equity and Options Trading Commentary

To get a better understanding of the option ideas expressed in this blog, buy my ebook today!

Friday, April 2, 2010

It's a Crude Summer: 3 Energy ETF's, 3 Option Plays

The major indices traded higher across the board Thursday, helped manly by basic materials and energy. Natural gas and crude oil futures traded higher to close the session by 6.33% and 1.85% respectively. In this article I will outline why I believe it is time to get long some black gold and discuss how I will play the move using options.

United States Oil Fund (USO)
Before I get into any details, I would like to give an ETF summary from Google Finance and the 6 month (daily) chart below.
United States Oil Fund, LP [USOF] is a limited partnership. USOF is a commodity pool that issues limited partnership interests [units] traded on the NYSE Arca, Inc. (the NYSE Arca). The Company’s general partner is United States Commodity Funds LLC (the General Partner) and is responsible for the management of USOF. The investment objective of USOF is for the changes in percentage terms of its units’ net asset value [NAV] to reflect the changes in percentage terms of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the changes in the price of the futures contract on light, sweet crude oil traded on the New York Mercantile Exchange (the NYMEX).
Click chart to enlarge
As we can see from the chart above USO has successfully broken and closed two consecutive days above the triangle pattern drawn in blue which is a bullish signal. Some resistance may come in around 41.50 - 42 per share, but I honestly believe we could easily see $100 per barrel by mid July so I think we will clear resistance setting new 52 week highs on this ETF.

USO Option Play: As stated I think we could see oil futures trade higher by 15 points or roughly 18% by mid July, therefore with the USO I am looking at opening July Vertical Call Spreads. Yes my prediction on crude oil translates into the ETF trading near 47-48 per share, however I must leave room for error. I would look at purchasing in-the-money July 40 Call options and immediately selling July 45 Call Options against them. As of current market data this spread could be opened for a theoretical price of $202 (plus any commissions) per call spread. This spread is currently in-the-money by 1.24 points so the premium paid for this spread is $78 or 78¢ per share; not too much considering there is over 100 days until the spread expires. If I were to get this spread I would look to take my first wave of profits if and when oil traded to $90 per barrel, then $95, and then $100. I would most likely take losses and stop out if oil trades near $78 and then $75 and try again if and when oil reestablishes an uptrend. If oil hits my target of $100 per barrel earlier than I expect such as by mid June, and we get a flashback of summer 2008 and every analyst on the street is slapping $150 - $200 price targets on oil, I would adjust my profit takes slightly, but remember three words we never hear an analyst say are: I was wrong...

ProSharesUltra DJ-AIG Crude Oil (UCO)
This is a leveraged ETF and should not be held for a long period of time, see my post Double and Triple Leveraged ETFs Revisited: The Real Decay to get a better understanding. Before I get into how I am looking at playing this ETF using options for a continued crude rally, I will give a summary of this ETF from ProShares and the chart below.
ProShares Ultra DJ-UBS Crude Oil seeks daily investment results, before fees and expenses, that correspond to twice (200%) the daily performance of the Dow Jones—UBS Crude Oil Sub-Index
Click chart to enlarge
UCO Option Play: Even though these leveraged ETF's decay with increased levels of volatility, I don't have a problem taking a bet on this ETF, because as stated multiple times already, I believe the trend for crude oil is up until mid July. As we can see from the chart above this ETF too has broken above the triangle pattern (drawn in blue) and closed two consecutive days. This chart predicts UCO trading to 15 and change in a very short period, therefore I have decided to structure a shorter term bet which will get me into this ETF for very slight premium. I would look at opening Vertical Call Spreads for the May option expiration. I would purchase May 13 strike call options and sell May 15 strike call options against them. Based on current market data this spread can be opened for a theoretical price of $80 per spread (plus any commissions). This ETF is currently trading at 13.65 which puts a premium of just over 1% on this spread. The best case scenario would be for this ETF to close and expire above 15 per share on May 21, 2010 which would result in a gain of 150% on the investment, however I rarely wait until expiration to close positions, therefore I would look to lighten up if and when crude works its way up to $90, and then $95 per barrel, and would most likely stop out and take losses if and when crude settled below $80 per barrel.

Energy Select Sector SPDR (XLE)
This ETF is one of the most liquid energy related ETF's out there, and does not invest directly in commodities, but oil and gas related companies. For those unfamiliar with this fund, I have listed the top ten holdings and the chart below.

Company Ticker
ExxonMobil Corporation (XOM)
Chevron Corporation (CVX)
Schlumberger, Ltd. (SLB)
Occidental Petroleum Corporation (OXY)
ConocoPhillips (COP)
Apache Corporation (APA)
Anadarko Petroleum Corp. (APC)
Devon Energy Corporation (DVN)
Halliburton Company (HAL)
XTO Energy, Inc. (XTO)

Click chart to enlarge
XLE Option Play: We can see from the chart above that a similar triangle pattern has emerged but has not yet been broken. Although the XLE has not broken and closed above it, I strongly believe it is only a matter of time before it follows the trend of the previous two ETF's discussed. I would like to see the XLE break and close two days above 59 per share, if and when it does, I will be looking at purchasing the June 30, 2010 60 strike call options (note these are the later of the two options which expire in June). Based on current market data the theoretical price is $180 per contract. This is actually the least volatile of the three ETF's discussed in this article, so although the speculation is the cheapest, the probability of having these calls payoff is also the lowest. If the triangle pattern is broken to the upside, the chart projects the XLE up to 63 per share on a short term basis. If I happen to get into these calls, I would look to cover some of my position by selling the 63 call options for the same expiration against the 60's (making the position into a vertical call spread) first if XLE traded to 60.50, then 61.50, and then to 63.

The ideas outlined above are bullish strategies and should not be considered if you think the ETF's will sell off in the near future. However if you feel the ETF's could move higher in the near future, this strategy could yield a nice gain.
To get a better understanding of stock options and different option strategies please check out my Simplified Stock Option Trading E-Books.

These are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

The reason option volumes have surged in the last five years is because they are a great way to hedge your portfolio as well as create income off of your shares (see chart here). Keep in mind when using this strategy it is essential that broker commissions are low enough to profit from the position.

Disclosure: Long UCO April 10 Calls, XLE June 59 Calls, Short UCO April 12 Calls, UCO April 13 Calls, XLE April 56 Puts

Sphere: Related Content

Hottest Blog Posts of All Time