Bobby Raines's Insights
Options Analyst Writer
October 5, 2015 - Take a Longer View When the Short Term is Uncertain
The stock market has been ugly over the last couple of months. The third quarter ended as the first losing quarter, which is pretty impressive given all the things that have happened over that span.
Maybe it's weakness in China’s economy.
Maybe it's persistent low inflation and slow wage growth.
Maybe investors were over-confident and kept bidding things up until they couldn't ignore the collection of reasons to worry anymore. Maybe it's uncertainty about what (and when) the Federal Reserve plans to do with interest rates.
Whatever it was, August was ugly for investors, and September wasn't much better. All three of the major indices are in correction territory, and it's hard to know where the market is headed next.
A lot of investors like to pull their money out of the market and put their heads in the sand when the market falls, buying back in only when they're convinced the market is going back up for good. The problem with that strategy is, of course, that it leads investors to sell low and buy high, which is the opposite of how money is made in the market.
One of the few universal rules in the stock market is that over a long-enough time period, the trajectory is always up. That means that when the market gets volatile and no one can tell what might happen next, the best thing to do is zoom out, look forward and adopt a posture of thinking for the long term. If you can take a longer view, you don't have to worry about where the market is going next.
We're going to take a long view this week with a sector that started to slide long before the rest of the market did… Energy.
Oil and gas started to fall late last summer and fall they did, from over $100 all the way to the high $30s at a couple of points. That obviously took the wind out of the sails of all the companies that are in the business of extracting and selling oil. The decline in their share prices has been slower than the fall in the price of oil, but just as inexorable.
Commodities are volatile; everyone knows that. When oil started to fall, everyone expected it to bounce back, but the bounce never came. For the most part, it still hasn’t. So oil and gas stocks have been in a long decline over the last year as investors have slowly given up on the rebound in oil prices that would support higher valuations. You can see that long slide in the chart of the Energy Select Sector SPDR (XLE) below.
Charts courtesy of www.stockcharts.com
As of now, oil still hasn't bounced, but it has been relatively steady at around $45 for a while. In fact, even while XLE is still in something of a downward trend, oil's recent price action is much more horizontal, which means we are very likely pretty close to the bottom of the slide for XLE. That doesn’t mean the ETF is about to shoot higher, but as time goes on, the chart should start to bend back upwards.
It's hard to imagine that the conditions that have led to low oil prices will continue indefinitely. Demand may not shoot higher, but with oil at $45, a lot of oil producers will cut back on production, particularly in regions where the cost of production is significantly higher.
I don't know exactly when oil will start to rise again, but as the oil industry adjusts to the new price of oil, profitability will start to creep back up for the big players. Some of the smaller producers, particularly in the fracking industry, may fail, but those failures will likely put their assets on the market at distressed prices, allowing the rich to get even richer.
Speaking of getting richer… The way I want to play this situation is with a diagonal spread, but with a little something extra as well.
First, the diagonal spread. This trade involves buying a long-term, deep in the money call, which will give us a claim on the stock, at a set price, at some point in the future. We will also sell a call against that position, which will help offset the cost of buying those shares. I'm looking at buying the January 2017 $45 call for about $17.25, and selling the March 2016-expiring $65 call for about $2.70. That gives us a net debit of $14.55. This trade will return a full profit of $5.45 per share if XLE is above $65 at March expiration. No worries though if it isn't, as you can always sell another call against the bought option, which will lower the net debit even further. The chance of XLE going even lower from here seems remote, although not impossible, so being able to buy the stock at $45 at any point between now and January of 2017, seems like a good opportunity. In this case, being assigned at $65 will give us a return of 37.46%. If XLE were to be below $65 at March expiration, and then go higher over the rest of 2016, the return could be even higher.
Investors looking for an additional hedge against a further slump in the price of oil could consider buying a March 2016, $55 put, for about $2.70. That raises the total cost of the position to $17.25, but if XLE falls between now and March expiration, we’ll be able to profit from an increase in that put’s value even as the price of our bought call falls. This lowers the target return on the diagonal spread to a still respectable $2.76 per share, or 16%. In this case, you're well protected if XLE falls below $55 between now and March, with your maximum loss capped at $7.25 per share, instead of losing your entire initial investment, which is possible if you were to just place the diagonal spread.
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