Contrarian Oil & Gas Trade

Although May WTI crude oil futures prices briefly traded as low as -40.32 last Monday before expiring last Tuesday, both the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) and the Energy Select Sector SPDR Fund (XLE) bottomed on March 18 and began trending higher. As implied volatility declines, a contrarian trade idea in the energy sector follows the Market Review with an updated SPX Rising Wedge chart.

S&P 500 Index (SPX) 2836.74 declined 37.82 points or -1.32% last week closing just above the 50-day Moving Average at 2807.71. After dropping below the lower boundary of a potential Rising Wedge, it rebounded back up to the moving average as if drawn by a magnet.

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After bottoming at 2192 on March 23, creating an impulse 3-wave, it quickly rebounded forming a potential small Rising Wedge. Then last Tuesday it gapped open lower closing below the lower boundary. However, the next day it advanced again instead of continuing lower putting the pattern in doubt. Should it continue above the red 50-day Moving Average in the chart above, it could be forming a normal uptrend channel ending the threat of a potential Rising Wedge for now. 

CBOE Volatility Index® (VIX) 35.93 declined another 2.22 points or -5.82% last week. Our similar IVolatility Implied Volatility Index Mean, IVXM using four at-the-money options for each expiration period along with our proprietary technique that includes the delta and vega of each option, declined 1.80 points or -5.52% ending at 30.83%.

The spike up to 77.15% on Monday, March 16, the day SPX declined 324.89 points, will likely mark the top for this market decline. After a brief advance last Tuesday that rattled the markets by an abnormal WTI crude oil futures decline, the IVXM continued lower.

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VIX Futures Premium 

This next chart shows as our calculation of Larry McMillan’s day-weighted average between the first and second-month futures contracts as of last Friday.

With 17 trading days until May expiration, the day-weighted premium between May and June allocated 68% to May and 32% to June for a premium of 1.73%, moving out of the bearish red zone below zero, into the neutral yellow zone between zero and 10%.

The premium measures the amount that futures currently trade above or below the cash VIX, (contango or backwardation) until front month futures contract converges with the VIX at the next monthly futures expiration on Wednesday, May 20.

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The relationship of the futures curve to the VIX, as measured by the premium, makes a good real-time sentiment indicator. 

For daily updates, follow our end-of-day volume weighted premium version located about halfway down the home page in the Options Data Analysis section on our website.

Contrarian Oil &Gas Idea

SPDR S&P Oil & Gas Exploration & Production ETF (XOP) 47.00 up 4.64 points or +10.95% in the last week.

After reaching an intraday low of 29.14 on March 18, it began trending higher on April 1 following WTI crude oil futures up and down until April 20 when it diverged and continued higher as the futures collapsed.

The three-month chart below shows XOP declining from 75 in late February following the WTI continuous futures prices lower until early March and then gapping lower below 40. On March 18, it made an intraday low at 29.14 marked with a red L. Then with a little imagination a Head & Shoulders bottom pattern appears among the volume bars at the bottom, just as it begin a new upward sloping trendline. Interestingly, on April 20 as the May futures headed into negative territory, it continued advancing despite all the negative crude oil rhetoric. With few exceptions, the financial media emphatically advised avoiding the energy sector.

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Bearish commentary is the most compelling at the lows since the bearish longs have already sold out. Apparently, when the Fed included junk bonds on their purchase menu it improved the survival changes for some of the smaller exploration and production companies in this ETF. 

Consider this risk reversal with a call spread. Sometimes call a "mambo combo."

With a current Historical Volatility of 93.65 and 90.96 using the Parkinson's range method, with an Implied Volatility Index Mean of 75.70 at .30 its 52-week range, the implied volatility/historical volatility ratio using the range method is .83 so option prices are somewhat inexpensive compared to the recent movement of the ETF even as the implied volatility declines. Friday’s option volume was 42,831 contracts traded compared to the 5-day average volume of 32,720 contracts with reasonable bid/ask spreads.

Without a decent short put implied volatility edge on Friday, the net debit was 1.04 (4.10 -2.14 +.92). While the long call spread by itself seems somewhat optimistic, adding the near term short put makes it more attractive although adding assignment risk. Use a close back below 40 as the SU (stop/unwind) or be prepared to receive the ETF on May 15. 

Strategy

Until SPX implied volatility returns to around 20%, option-selling strategies remain favorable; especially those with limited and defined risk such as Iron Condors and Short Put Spreads as well as short puts on stocks with the intention of being assigned.

Since the potential Rising Wedge shown above appears less relevant, keeping a SPY out-of-the-money put spread provides some insurance with defined and limited cost as it continues toward the 62% Fibonacci ratio at 2937 before completing a still possible, but less likely Elliott 4-wave anytime soon.

"It's not the economy, it's the liquidity, stupid!" If this anonymous quote was valid last October, then it's even more relevant now as the Fed's action so far accounts for about 22% of the GDP, with the G-men (and women) adding another 13% of "Mo Money" for total support of 35%.

Positive momentum by the popular large-capitalization stocks, along with declining options implied volatility, improving VIX futures premium, and continuing market breadth improvement by our preferred McClellan Summation Indicator, all reflect increasing bullish sentiment.

Summary

Until last Tuesday, a potential Rising Wedge that could the picture and increase the likelihood of retesting the March 23 low remained possible. However, last Wednesday the S&P 500 Index recovered enough to reduce the chances of activation. While above the 50% retracement level it may continue higher enough challenge the 62% Fibonacci ratio and beyond. In the meanwhile, abnormal WTI crude oil futures trading may have created a contrarian opportunity in the exploration and production sector.