If Oil Flies, This Fly Will Profit

by Tyler Craig | December 3, 2012 1:16 pm

Market rallies come in all shapes and sizes. Some are broad and far reaching, lifting sectors of all stripes. Others are narrower, enveloping only a few stocks that act as market leaders.

The current rally that has lifted the S&P 500 Index a quick 5% since the Nov. 16 low can be considered one of the former; the strength has seeped into everything from retail and tech to basic materials and industrials.

And yet, the resurgent bull hasn’t buoyed every asset class tied to the risk-on ship equally.

One member of the commodity club left adrift during the multi-week rally is crude oil. While the S&P 500 is up 5% since bottoming in November, crude — at least as measured by the United States Oil Fund (NYSE:USO[1]) — is up a mere 1.9%.

Of course, oil largely sidestepped the post-election bloodbath, so perhaps its lack of participation in the market rebound is because it wasn’t nearly as oversold.

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A brief analysis of USO’s price chart reveals that neither the bulls nor the bears have really had the upper hand of late. For the past six weeks, the oil ETF has meandered aimlessly in a tight range between $31 and $32.50.

On Monday morning, USO attempted to break above not only the resistance zone of its recent range, but also its 50-day moving average. Now might be an appropriate time to consider bullish trades for those who believe oil is going to play catch-up to the broader market run.

Normally, I’d suggest selling puts on a low-priced ETF like USO, but with implied volatility being as low as it is, the amount of premium in December and January options is paltry. In light of these relatively cheap options, a better strategy might be buying a January call 32 x 34 x 36 butterfly.

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The position is entered by buying one Jan 32 call, selling two Jan 34 calls and buying one Jan 36 call for a net debit of 50 cents or better. The accompanying risk graph displays the potential profit and loss of the position. The max loss is limited to the initial 50 cents paid and will be incurred if USO sits below $32.50 or above $35.50 at Jan expiration. The max reward is $1.50 and will be captured if USO sits right in the heart of the fly at $34.

Rather than trying to eke out every last ounce of profit, traders should consider closing the position when they’ve captured anywhere from a third (50 cents) to two-thirds ($1) of the max profit.

To minimize risk, traders should exit if USO falls below support at $31.

As of this writing, Tyler Craig owned neutral option positions on USO.

  1. USO: http://markets.financialcontent.com/investplace./quote?Symbol=USO

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