Stocks were down across market capitalizations and geographic markets last week, with the S&P 500 losing roughly 0.9%, and all nine of its sector ETFs down, too. The Chinese stock market crashed on Thursday, when regulators put additional curbs on the use of margin, and equities in developed and emerging markets also lost ground. Bonds were up in the U.S. and other developed markets, and even emerging-market debt caught a bounce on Friday. Precious metals were down for the week, but oil made a surprising rebound of nearly 4.5% on Friday, vaulting above the $60 level in the U.S.
The chart above depicts the past three months of trading for the United States Oil Fund (ticker: USO), which is an ETF that seeks to mirror to percentage gains and losses of West Texas Intermediate crude oil. The ETF is priced so that one share is roughly equivalent to one-third barrel of oil. A 1:3 split bringing USO‘s share price in better alignment with WTI would probably boost the ETF’s popularity, but I digress.
Back in BigDeal #1, when USO was at $20.39, I forecasted lower oil prices. USO ultimately dipped to as low as $19.09 Thursday before it came roaring back the next day to close at $20.31. Now I think oil is heading lower once again, as its recent pop was prompted by profit-taking quickly turning into a short squeeze of over-leveraged oil bears. Yes, the U.S. oil rig count fell by a greater-than-expected number when results were announced on Friday, but production has yet to drop off – and OPEC is unlikely to call for cut-backs when the cartel meets on June 5.
June 5 is also the day U.S. nonfarm payroll numbers for May will be released, and Greek’s next payment to the International Monetary Fund will be due – that’s a lot of data for the markets to consider. I look for stocks to trend lower into the end of the week, and then for things to get explosively volatile on Friday.
WTI oil has been unable to sustain prices over $60, and I don’t think the fundamental outlook for oil has changed since I first went bearish on the commodity when it topped in early May. Rig counts are falling, but production is rising – and if prices stay at $60 or above, more U.S. shale production will come online, knocking the prices back down.
Long-term, there are many fabulous values in the oil space, particularly among U.S. shale drillers, but also among large integrated stocks. The Energy Select Sector ETF (XLE) fell Friday, even as oil surged, and XLE stocks have only had a 34.3% correlation to USO over the past six months, after having an 89.9% correlation the prior six months. As the weaker players are shaken out, the best drillers are getting even more efficient, and they’re able to wring out profits in the $50-60 range while keeping production high enough to discourage the less-efficient drillers from coming back online. Goldman Sachs, meanwhile, issued a letter on Thursday projecting WTI at $45 a barrel by October.
The dollar has continued to show strength and this trend is likely to persist. Nobel laureate and political insider Robert Shiller told CNBC this morning that the Fed needs to hike interest rates to pop the many bubbles that are forming around the U.S., including in the stock and bond markets. A rate hike would strengthen the greenback further, and since oil is priced in U.S. dollars, a strong dollar is bad for oil. Over the past year, the PowerShares DB US Dollar Bullish ETF (UUP), which measures the dollar’s strength against a basket of foreign currencies, has had a negative 95.7% correlation to USO.
Fears of a Greek default and “Grexit” from the EU will give the dollar strength, weighing on oil. A bullish employment report on Friday will convince traders a rate hike is more likely, strengthening the dollar and weighing on oil. OPEC is unlikely to cut production, and that will put downward pressure on crude, too. And even if U.S. employment numbers are worse-than-expected, that would undermine the “strong economy” thesis necessary to push oil’s price higher – oil seems to be in a nearly no-win situation here.
We’ll buy (buy-to-open) USO’s $21-strike July puts. This will be a simple, unhedged put option, not a spread.
As of 11:27am ET, shares of USO were trading at $20.12, and the bid/ask on its $21-strike July puts was at $1.47/$1.49. This gives the $21-strike puts $0.88 in intrinsic value, which is nearly 60% of the premium we have to pay – that’s an attractive risk/ reward. Nearly 300 of the $21-strike July put contracts had already changed hands in the first two hours of trading, and 18,334 remained in open interest.
Goal of the play: We’ll shoot for 30% gains on this unhedged, single option trade. Assuming an entry price of around $1.50, that would give us a price target of $1.95. We’d hit this level in intrinsic value alone if USO falls to $19.05, a level it was just $0.04 away from on Thursday. And, of course, the July expiration gives us six weeks for our trade to develop.
Risk: With a presumed entry of around $1.50, we’ll risk a maximum of $1,800 by entering this play on 12 contracts. You may choose to use a limit order at the point of purchase, pricing it $0.05 to $0.10 above the current ask. I’d recommend entering the play so long as the intrinsic value of the puts (the $21 strike minus the current share price of USO) remains over 50% of the premium.
#1) PM $80/$82.50 September debit put spread
Entry price and date: $0.97 on 5/18/15
Position Size: 20 contracts per leg
Current bid/ask: $0.85/ $1.36 (11:35am ET)
Target: $1.15 bid
Over the weekend, I was very happy to learn that some BigDeal subscribers have already taken profits on the Phillip Morris International (ticker: PM) debit put spread. As I stated in issue #4, I’ve found this trade to be very frustrating, since the puts haven’t performed the way the underlying shares would seem to imply they should. PM has dropped virtually every day since we entered the play (encircled in the chart below), but thanks to a very poor entry of $0.97, we haven’t been able to reach our “official” $1.15 price target.
I understand that most subscribers entered this play at a much more favorable point, possibly $0.80 or less. I still expect this spread, which doesn’t expire until September, to hit a $1.15 bid price, but if you’d like to take profits at $0.95 or so, by all means do. The spread will likely hit that level later today.
#2) MCD $95/$100 June debit put spread
Entry price and date: $2.15 on 5/21/15
Position Size: 9 contracts per leg
CLOSED AT $2.60 or higher on 5/28 for gains of at least 20.9%!
#3) BA $150/145 July credit call spread
Entry price and date: $1.45 credit on 5/26/15
Position Size: 5 contracts per leg
Current bid/ask: $1.01/$1.10 (10:45am ET)
Target: Hold until expiration for 100% of $1.45 credit received
Our Boeing (ticker: BA) credit call spread has worked out marvelously thus far. We collected a $1.45 credit and we’ll be able to keep the whole thing – around $725 total, assuming a maximum $2,000 risk – so long as BA stays below $145 through the third week of July. Given how the stock performed after very briefly spiking above that level on Thursday, I think this is a safe play.
Right now, we could cover and close this spread for a $0.35 gain. That would give us profit of just $175 on the $2,000 risked, which is below our standard threshold over 20%, or roughly $400 gains. There will be losses, of course, and the losses could be greater than $400, which is one reason to consider taking the $400 profits whenever they’re there – but it’s also an argument for holding on to the potential of larger gains, such as the $725 we can net if BA stays below $145. Act in accordance with your risk tolerance, should the ask price of this credit spread fall to $0.65, which is where we could take $400 in profits, but hold for now.
#4) QQQ $113/110 June credit call spread
Entry price and date: $1.36 credit on 5/28/15
Position Size: 12 contracts per leg
Current bid/ask: $1.16/$1.18 (11:54am ET)
Target: Hold until expiration for 100% of $1.36 credit received
Our QQQ June credit call spread continues to look good, too. We received a $1.36 credit just two trading days ago, and the ask on the spread dropped to as low as $1.09 in early trading today. As above, consider covering if the spread falls to $1.02, which would allow us to net $0.34 per share, $34 per contract, or $408 total. We’ll revisit this strategy in the next issue of the BigDeal Newsletter.
Jason Seagraves is a 37-year old writer, options trader, entrepreneur, homeschool dad, and evangelist for free-market economics. He launched a successful dot-com business while still in college in the late 90’s, and then went back to school to graduate with a degree in Business, concentration in Finance, from Siena Heights University in 2006. That year, he also earned a Series 7 stockbroker’s license, but opted to pursue a career in freelance writing. From 2008 through 2013, he worked as a “ghostwriter” for a popular stock and options trading newsletter, before joining up with Dividend Lab for a stint in 2014. Now he’s back providing market commentary and actionable options trades for the BigDeal Newsletter, and he’s happy to be here!