Since peaking in late February, the Energy Select Sector SPDR (NYSE:XLE) has been under pressure far more than the overall market. The S&P 500 peaked almost a month after the XLE before experiencing some volatility. So far the S&P has dropped approximately 4.5% from its peak, while the XLE has declined over 13% from its February peak.
Click to Enlarge Looking at the weekly chart of the XLE, we see the steepness of the decline during the past 12 weeks. The ETF dropped below its 13-week and 52-week moving averages and is sitting just above its 104-week moving average. These moving averages might seem a little unorthodox from what most investors look at, but they represent one-quarter (13 weeks), one-year (52 weeks) and two-year (104 weeks) time frames. While they might be unorthodox, I find them to be more relevant.
Something else we see in the chart is the long-term trendline that connects the lows from 2009, 2010 and 2011. Notice that the weekly closing prices are used because the closing prices are more important than the intraday or intraweek moves. We also see that the weekly slow stochastic readings have reached an oversold level and the 10-week relative strength index is approaching an oversold reading.
The last time the XLE hit the trendline was last September, and this also was the last time we saw the overbought/oversold indicators reaching oversold levels. After the fund hit that support line and reached oversold levels, it jumped almost 30% in the month of October.
In June 2010, the fund created the second point that helped create the trendline when it bottomed near the $48.50 level. Over the next nine months, the XLE jumped more than 66% from the low to the high.
While it is too early to tell if the XLE will be able to use the trendline as support in the near future, it certainly will be worth watching. The previous points of reference have created incredible opportunities. If we see the fund hit oversold levels and touch the trendline, it will be worth going long.
The whole idea of investing and trading is to find situations where probability is on your side. Given the way the XLE has rallied after hitting the trendline and hitting oversold levels on the weekly charts, the probability for a sharp bounce is high.
This might even be a situation where it is worth using a leveraged ETF. The risk-reward ratio will be well worth it. To give you an idea, the Direxion Daily Energy Bull 3X Shares (NYSE:ERX) fund jumped 126% during the rally last October, and it jumped more than 320% from June 2010 to March 2011.
The ERX currently is trading just above the $40 level, and there is support right around the $36 level with a second layer of support at the $30 level. These would represent additional declines of 10% or 33%, but when we are talking about upside potential of 100% or more, that risk is worth it.
As of this writing, Rick Pendergraft did not hold a position in any of the aforementioned securities.