Shares of the Energy Select Sector SPDR Fund (NYSEARCA:XLE) are finally firming after a brutal selloff. The XLE exchange-traded fund is comprised of the major oil stocks and closely follows the price of crude oil.
And fears surrounding the coronavirus outbreak have pummeled oil prices. Now that oil has once again found some semblance of a bottom, expect oil stocks and XLE to head higher over the coming weeks.
Oil prices are once again approaching major support at the $52 level. The 14-day relative strength index is deeply oversold with the lowest readings of the year near 20. The last time crude was at similar oversold levels marked a significant low in prices.
Moving average convergence/divergence is also at extremes, while Bollinger Percent B just went negative. Oil is also trading at a large discount to the 50-day moving average, which has been a sign of an impending rally in the past.
Oil Price Charts
The reaction earlier this week was also encouraging. Crude oil held support at the $52 level and then bounced nicely off the lows of the day. The price action is very akin to the previous two times oil sold off sharply from similar areas (highlighted in gray on the chart). Look for a bounce over the coming weeks in crude.
The major oil and energy names dominate XLE. Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX ) compose over 40% of the ETF’s weighting. Normally oil stocks and oil prices are highly correlated, which makes sense. Lately, however, that correlation has broken down. XLE has been a relative underperformer to oil over the past few weeks. Expect that divergence to start to converge. Oil stocks should be a relative outperformer to crude over the near term.
It wasn’t that long ago that upside fears swirled in the oil market regarding the U.S.-Iran tensions. Calls for oil going to $100 were bantered about. That never came to fruition.
In a similar vein, this time the Wuhan coronavirus has put downside fears in place. Once again it is likely that the fears will be overblown.
How to Trade the XLE
As Warren Buffett said, “Be fearful when others are greedy and greedy when others are fearful.” That adage certainly holds in the oil market. Oil markets are self-correcting. Higher prices lead to more supply. Lower prices lead to less supply.
Stock traders should look to buy XLE on any weakness. The initial upside profit objective would be a move back to the $58 area. A meaningful break below $52 would serve as a viable stop-out point. XLE also pays a very healthy 4.1% dividend, more than double that of the S&P 500.
Option players may want to take advantage of heightened implied volatility and sell the Feb $54/$50 bull put spread for 50 cents net credit. Maximum gain on the trade is $50 per spread with maximum risk of $350 per spread. Return on risk is 14.3%. The short $54 strike provides a 1.8% downside cushion to the $55.30 closing price of XLE.
As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a free trial of the Delta Desk Research Report can email Tim at firstname.lastname@example.org.