USO – The Case for a Crude Reversal

by Tyler Craig | October 23, 2013 2:06 pm

Despite a favorable backdrop for risk-on assets, crude oil has been crumbling for the past two months. With Wednesday’s 2% downdraft, oil has now tumbled 14% since peaking at $112 in late August.

What makes the persistent weakness in crude so interesting is its historical tendency of moving with stocks, not against them.

Consider the accompanying 2-year weekly chart of Light Crude Oil with a 10-period correlation study comparing the commodity to the S&P 500. Oil’s stark disconnect with stocks has driven correlation deep into negative territory revealing its recent tendency to move in the opposite direction of stocks.

In fact, correlation is at -o.82 — its lowest levels since 2008.

WTIC Weekly 1024x472 USO   The Case for a Crude ReversalClick to Enlarge

Curious, to say the least.

While oil may continue its plunge, two technical areas of significance are approaching that could cause a rebound in the beaten-down commodity. First, the old resistance zone in the $96 to $97 area may turn into a new support zone. Would-be buyers who missed the initial breakout in early July are likely to use the current dip as an opportunity to snatch-up oil in the same area. This influx of demand should help to stem the current decline.

Fibonnaci retracements add further significance to the $96 area. Following Wednesday’s down move, crude now sits at the 61.8% retracement level from its April to August upswing. Upon confirmation of the price of oil bouncing, this dip represent a low-risk entry point for buyers.

WTIC fib 1024x453 USO   The Case for a Crude ReversalClick to Enlarge

 The United States Oil Fund (USO[1]) is perhaps the most popular ETF available for equity and option traders to play the action in oil. While stock traders could buy the ETF straight up, the low price tag makes it an optimal candidate for selling naked puts.

Investors should sell the Dec. 33 USO put for 57 cents or better. The max reward is limited to the initial 57-cent credit and will be captured provided USO sits above $33 at December expiration. The expiration breakeven for the trade is all the way down at $32.43 which means USO would have to drop more than 6.7% for you to lose at expiration.

This is why the naked put trade is considered a high probability play. There is a strong chance that USO goes up, sideways or down less than 6.7% in the next two months, particularly given that it’s already fallen 14%.

To minimize the risk involved, investors could exit the trade by buying back the put if USO falls beneath the expiration breakeven of $32.43. In timing the entry, consider waiting for oil to show signs of rebounding before pulling the trigger.

So far it’s languishing at support with buyers yet to aggressively bite.

At the time of this writing Tyler Craig did not hold a position in any of the aforementioned securities.

Endnotes:
  1. USO: http://studio-5.financialcontent.com/investplace/quote?Symbol=USO

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