by Tyler Craig | May 31, 2013 1:14 pm
The consolidation in the energy sector has come in the form of a pennant pattern. Marked by lower lows and higher highs, the pennant suggests an increasingly aggressive tug-of-war between buyers and sellers. With the apex of the pattern looming closely, perhaps the victor of the current struggle is about to be declared.
While guessing the eventual winner without any type of confirmation might be cast by some as a fool’s errand, history suggests most continuation patterns (such as pennants, flags and triangles) end up breaking in the direction of the existing trend. And so, with SPDR Energy (XLE) still firmly in an uptrend, we could argue the ongoing consolidation is more likely to break to the topside.
Click to Enlarge Further bolstering the bulls’ grip on the energy space is its continued outperformance of the S&P 500 Index. As shown in the bottom panel of the accompanying chart, its Comparative Relative Strength (CRS) remains in the uptrend that kicked off in mid-April. Provided it can remain above the blue trendline, the sector looks like a healthy place to be.
Click to Enlarge One of the more appealing stocks within the sector is Western Refining (WNR). While many of its peers broke out to new 52-week highs alongside the energy sector, WNR spent the past two months building a base between $30 and $33.30. It’s been testing the upper end of the consolidation zone over the past few days and looks poised for a breakout.
Here are two option plays worth consideration.
A simple yet highly leveraged way to exploit the coming breakout is to purchase the July 32 put for $2.70. The max risk is limited to the initial debit of $2.70, and the max reward is unlimited. To reduce the risk involved, you could exit if WNR falls back below the $32 level. Using a risk graph, the estimated loss comes out to about $100.
If you’re looking for a higher-probability play, consider selling the July 30 put for $0.70 or better. The max reward is limited to the initial $0.70 received. Since the short put obligates you to buy 100 shares at $30, the theoretical max risk is $30 minus the premium received, or $29.30. However, you could exit to minimize the loss if WNR falls below the support zone at $30. Using a risk graph, the estimated loss comes out to $120.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.
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