After bottoming out around the $60 level on Sept. 29, shares of the Energy SPDR (XLE) — which is comprised of the top oil stock names like Exxon Mobil Corporation (XOM) and Chevron Corporation (CVX) — have been on a major bull run, moving up nearly 15% over the past eight trading sessions. This easily outpaced the gain in crude oil prices during the same period (10%), as oil prices briefly hit the $50 level on Friday before retreating.
Shares of XLE finally showed some weakness on Friday, though, closing lower by 45 cents after trading higher earlier in the session.
From a technical standpoint, however, XLE is getting into overbought territory, with 9-day Relative Strength Index readings over 70 for only the third time over the past two years.
Click to Enlarge The prior two instances marked very opportune times to take a short position in XLE, as seen in the chart.
Shares of XLE also stormed past the 50-day moving average of $65.15, and are currently trading above this average by 5.82%. The prior two market tops saw the 50-day MA exceeded by only 5.63% and 4.91%, respectively, before shares began to pull back , so XLE definitely is getting a little frothy from a price action standpoint.
Fundamentally, the weaker dollar and concerns out of Syria have provided a short-term positive backdrop for oil stocks, but longer-term, oversupply concerns still are still the predominant theme.
Canadian oil production is expected to increase over 500,000 barrels a day in the next year, with Alberta oil sands projects being the largest contributor. The Energy Informatiion Administration said Wednesday that oil inventories in the U.S. rose 3.1 million barrels, versus expectations of only a 2.55 million-barrel increase. The Department of Energy reported that U.S. oil production rose to 9.17 million barrels this week, as compared to analyst estimates of 9.1 million.
Implied volatility, which is a measure of option pricing, has dropped sharply owing to the recent rally, which is also a contrarian bearish signal. It also makes long option strategies more attractive, setting up a straightforward put purchase as an effective way to play a pullback in the XLE.
To take a guarded short position in oil stocks, I would buy the XLE Dec $69 puts for $3.20 or better. This is a defined-risk trade, with the maximum loss being the initial option premium of $3.20. I would use a move back toward the 50-day moving average level of $65 as my first profit objective, with a secondary objective at the recent lows of $59.50.
From a risk management standpoint, I would look to exit a portion of the position if the anticipated pullback in oil stocks fails to materialize by November expiration.
As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities.
