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Game the Dollar’s Demise With Oil Puts

Energy rises amid the greenback's weakness


The Energy Select Sector SPDR (NYSE:XLE) claimed the top spot in sector performance last week, as well as the entire month of January. The uptick in demand for energy-related stocks led the sector to outperform the S&P 500 Index by an impressive 3.2%. Not surprisingly, the resurgence in energy came amid a broader rally in the commodity space, aided by a weakening U.S. dollar.

Long perceived as a safe haven, the U.S. dollar has been under pressure this past month as investors have ventured into riskier assets in search of better returns. The stock market and the U.S. dollar typically exhibit a negative correlation, so a falling dollar should continue to benefit not only commodities but the broader market as well.

The attached chart includes a correlation study at the bottom revealing the dollar’s correlation with the S&P 500 Index currently stands at -0.65.

The recent action in the greenback has developed the right shoulder of a head-and-shoulders pattern, which is a classic topping formation with ominous implications — at least for dollar bulls. The shift from higher highs to lower highs reveals a transfer of power from the bulls to the bears. As shown in the above chart, the $79 level on the U.S. Dollar Index is acting as neckline support for the pattern. A breach of this pivotal level could send the buck back down to its 2011 lows in the $74 area.

Traders looking to exploit continued weakness in the U.S. dollar have a few different plays at their disposal. While a bearish bet on the buck might be the most direct way to profit from its downward spiral, there aren’t a whole lot of alluring vehicles available for stock traders to make such a play. The PowerShares DB US Dollar Index Bullish Fund (NYSE:UUP) boasts plenty of trading volume but virtually no volatility. Its average daily move is a pathetic 8 cents, so it’s not exactly movin’ and groovin’.

As an alternative, consider initiating bullish positions on commodities such as oil, which should continue to benefit from the dollar’s demise. The United States Oil Fund (NYSE:USO) finds itself in the midst of an uptrend and has recently formed a shallow pullback, providing a lower-risk entry point. The implied volatility of USO options remains high relative to the actual movement we’re seeing in the ETF, so I’d favor selling options here.

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One higher-probability play worth consideration is selling a March out-of-the-money put option. By selling a shorter-term option, you’ll capture a higher rate of time decay. And using out-of-the-money options provides a higher probability of profit. The March 34 puts can be sold for around 68 cents. The potential profit is limited to the initial 68 cents and will be captured provided USO remains above $34 by March expiration.

To minimize the risk, consider closing the position if the USO breaks below its 50-day moving average at $33.30.

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

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