The two great dangers we currently face are thus. First, upheaval in the Middle East, which threatens to unseat at least one significant oil-producing regime and pressure oil prices beyond what's economically sustainable at this phase of the global recovery.
Second, Western central bankers (there's always a problem with central bankers), who may feel the urge to hike interest rates in response to what may be only temporarily higher readings on the CPI.
Of the two, the one gaining most attention is the Middle East.
The remaining oil-producing regimes of stature, Algeria, Saudi Arabia, Iraq and Iran, may or may not face Egypt/Libya-type revolutionary stirrings. And if they do, it's equally uncertain whether the current regimes will be unseated. That notwithstanding, it's the very uncertainty of the current situation that fuels oil speculation more than anything else. We look for that uncertainty to pass rather quickly.
As far as central banks go, we admit the thought of Libyan style revolts against these autocratic, money-diluting ogres meets with our staunchest approval. Until then, however, we'll be forced to deal with these heavy hands and their penchant for wrong-headed meddlesome monetary activity.
Look for Western Bank Heads to Leave Well Enough Alone
Of course, it's debatable whether the inflation the West is exporting via currency devaluations is alive and well in the West itself. Plenty still worry about deflation, while others are convinced that the Fed is already behind schedule in employing the ratchet.
Our thoughts are that the inflation monster is still benign, and any effort to slay it now would only bring greater beasts in its stead.
Look for the bankers to let go the reins until the greens of her eyes have been seen.
This Week's Trade
We are strong believers in the power of trading overbought and oversold stocks against one another. And the best way of doing that, in our opinion, is via a zero premium trade.
What in the name of Corrigan is a 'Zero Premium' trade?
Though we've periodically addressed the workings of the zero premium trade, we see from the number of talkbacks we've garnered on the topic that it's time for another (brief) review.
Here it is:
The zero premium trade is a bet that costs nothing to implement – hence the name 'zero premium'. You buy an option (or a bunch of options) for a dollar and sell an equal number for the same dollar. Your only cost is commissions.
The bet is that the long option will increase in value at a faster rate than the short option, thereby netting you a profit.
So for example, if you believed Exxon Mobil would outperform the broader energy sector over the next three months, you might purchase a MAY XOM CALL for $2.00 and sell a May CALL on the Energy Select Sector SPDR (NYSE:XLE) also for $2.00.
It's important that both options trade for the same price and expire at the same time.
If you're right, and XOM climbs faster than the sector, your XOM CALL will appreciate at a faster rate than your XLE option. The increasing price spread between the two is your profit.
If the broad oil sector falls, and XOM falls with it (but at a slower rate), you will also profit. If they're both below strike at expiry, you lose only the cost of your commissions.
Can We Lose?
The only way you can lose money on the trade is if you haven't done your homework, and the XLE option appreciates at a faster rate than the XOM. If this happens, it's advisable to close the trade early, take a minimal loss and look for new opportunities.
Caveat emptor: zero premium trades are not advisable for those who are unable to monitor them. The options market moves swiftly, and losses can accumulate quickly. Of course, we here at Oakshire have our eyes peeled throughout the trading day, but as we're only in touch with you on a weekly basis, it's best you follow our updates closely and keep a certain vigil of your own.
That said, should the trade, indeed, move against us, there are a number of methods by which we can repair it.
Finally: most brokerages require you to put up significant margin on the short option position. Speak with your representative regarding company policy on short options.
And now for something completely relevant
The foregoing was purely theoretical. Now let's look at a real-life trading example.
Margin requirements on commodities have been rising recently in the face of record open interest levels and wildly rising commodities. Cotton, coffee, silver, sugar, rice and soybeans, to name just a few, have seen rising margin percentages for the last three months. The Chinese, too, have raised margin on the Shanghai Exchange on everything from copper, aluminum and gold to rebar and fuel oil.
Stateside, the Nymex and the Intercontinental Exchange were the most recent actors, raising rates for two straight days on crude contracts as oil pushed north of $100.
Essentially, it's now more 'expensive' to hold a crude contract than it was last week, and that's likely to take some steam out of the current rise. In the increasingly likely event of a drop in crude, we're also apt to witness much earlier and more forceful liquidations than we would have seen a week ago.
Current equity margin levels are now holding at levels last seen when Lehman Bros. went thwack!, and put additional pressure on firms and individuals to close out losing trades earlier.
To sum: there's a heavy finger on the profit-taking trigger.
Moreover, technically, oil is trading three standard deviations above its 50 day moving average. That's the first time that's happened in over a decade. Look here:
Our trade this week is based on the premise that the revolution called Jasmine is now a has-been and oil's on its way back to earth. We're buying XOM July 80 PUTS for $2.55 and selling USO July 38 PUTS for the same price. That's right, a zero premium trade. Here's a chart comparing the two:
XOM (in gold) has outpaced the NYMEX crude ETF, USO (seen above) by a 6 to 1 margin this year, despite surging oil prices.
When the tide turns, we see XOM retracing at a more rapid rate than the stolid USO.
Wall Street Elite recommends buying XOM July 80 PUTS for $2.28 and selling USO July 38 PUTS for at the same price or higher (making it and even swap or a net credit).
With kind regards,
Hugh L. O'Haynew,
Analyst, Oakshire Financial
