Discover more from AlphaCharts Blog
Asymmetric Opportunity 22.10.11
Taming the oil trade with options and savings rates
ICYMI, I broke this news on Twitter:
At the start of last year, when meme & growth stocks were flying, I had just started this blog and was a single guy. Then I met my (now) wife, and we dated for a year before we got engaged. Those were relaxed times.
Since this Spring, things got busy as we planned our wedding and renovated our apartment. Probably a good thing to be preoccupied as it’s been a dodgy trading environment.
But life has been something else after the baby arrived. Amazing how much your life can change in such a short period of time.
We’re getting some help this week, which gave me some time to think of a trade idea.
Good trading is all about pursuing asymmetric opportunities (ie. trades with a great risk/reward ratio).
These opportunities can be achieved by patiently following big trends with a sound risk management strategy. Breakout trading has always been my big focus, and in many ways, it resembles a call option’s payoff:
I want to discuss a setup involving call options that has excellent risk/reward in a market otherwise full of landmines.
Two pieces of the trade
1. Money market funds
As we looked at in the last blog post, the broad market is in a downtrend. It’s not a bad idea to have one’s portfolio in money market funds yielding 4% until market conditions improve. I discussed this here & here.
2. Energy call options
There’s lots of reasons to be bullish on oil:
Relative strength: Fossil energy (oil, gas, and coal) is the strongest area of the market, and it’s been that way all year long. This has been a resilient, albeit shaky trend. Last week, XOM was up 16%. That was the largest weekly % gain on record for the largest oil company and one that’s been around for more than a century!
Monthly charts: Various oil stocks came out of multi-decade bases in 2021-2022 (see CNQ, IMO, EQNR, ENB, etc.). More recently, Brent and WTI futures hit major support.
Weekly charts: Oil and coal stocks have formed tight 6-month consolidations within strong uptrends. Some made new breakouts last week (eg. COP, FRU.CA, PSK.CA). Watch for more breakouts in names near 52-week highs (eg. XOM, MUR, MPC, HES, BTU, OXY, TOU.CA, ERF.CA, BIR.CA, NVA.CA, etc).
Commercial hedgers have their highest net exposure to oil in 6 years.
Uncorrelated: Oil rising while the broad market is weak is a real possibility. As Shane Murphy points out, the correlation between crude oil and the S&P 500 went into a negative regime last summer (tweet). Shane also has this awesome 100-year chart showing the commodities vs. stocks ratio potentially entering a new regime.
The problem with the oil trade is that it's extremely volatile. In the winter, WTI oil doubled in less than 3 months. Then in the summer, it fell almost 40% in 3 months. Last week alone, it was up 17%. Sheesh.
A small allocation in long-dated call options is a great way to participate in oil’s upside momentum over the next year while having tight risk management.
Combining the pieces
Suppose we allocate 96% of a portfolio in money market ETFs yielding 4% and the remaining 4% in long-dated (1-year), out-of-the-money (OTM), American-style call options on oil futures. The money market funds pay for the premium on the calls, while the calls let you participate in oil's upside.
But what strike price should we use for the calls?
Below is the portfolio gain/loss with a 4% allocation in 1yr oil call options for various strike prices.
Data source: barcharts.com
Note: the payoff shown above is the contribution of the call options to the overall portfolio’s return - it excludes the contribution of the money market funds. Also, it’s the payoff at expiry – if the targets are hit before then, the payoff will be larger as these American-style options will still have some time-premium left.
Let’s look at a $140 strike price on the 1yr oil calls.
Very little downside: If oil stays below $140 in next year, your portfolio is unchanged. The 4% loss on the worthless call options is offset by the 4% gain on the money market funds.
The downside is considered small but we can’t say it’s zero: First, the interest earned on the money market fund is taxed so it’s not quite 4%. Second, while there’s no price risk on the money market funds, their distributions will fall if interest rates fall.
Unlimited upside: Any oil price above $140 over the next year results in a profit.
If for example, oil goes to $150 (ie. the highs from 2007), a 4% allocation in the call options will boost the entire portfolio by 11% (net of the option premium) plus another 4% thanks to the money market funds. Now if oil goes to $200/bbl, the entire portfolio doubles!
Contrast the above trade idea with having a 100% allocation in oil futures. You have similar upside (eg. If oil goes to $200, portfolio doubles), but the volatility and downside risk is big even with a stop loss. You’re also more likely to get stopped out early (at a loss). You don’t hear from all the crypto bulls that were tweeting #IrresponsiblyLong last year. 🤦🏾♂️
The call option strategy instead lets you be very patient with the trade, even giving it a full year to work. In a market full of failed moves and high volatility, this is highly beneficial.
The trade idea presented in today’s post is a set-and-forget one. No monitoring charts and trying to adapt to every move. Something I need right now during a busy time in my personal life.
Important Disclaimer: This blog is for educational purposes only. I am not a financial advisor and nothing I post is investment advice. The securities I discuss are considered highly risky so do your own due diligence.