Catching a Falling Knife

Back at the end of January, Richard Croft posed the question “Has Oil Bottomed?“. At the time of publishing, oil was trading at around $46.00 per barrel. In his article, he cites a number of supply and demand and geo-political considerations supporting the potential for range bound trading activity between $40.00 and $60.00 per barrel through out 2015. He offers the covered call strategy as a way to take advantage of increased option premiums due to volatility and enhance cash flow as some of the big name energy companies share prices consolidate and advance slowly higher.

This is a great approach for a more passive investor. However, I think there may be an opportunity to take advantage of a short term upswing in oil for the more active reader.

In addition to Richards considerations, I would also look at the trend of the U.S. Dollar. If we plot the U.S. Dollar Index against Light Sweet Crude Oil, you will notice the inverse relationship of the two. Since commodities in general are priced in U.S. Dollars, when the USD is strengthening, commodities tend to weaken and vice versa. Of course, from time to time, supply and demand forces and geo-politics will exert an influence. However, the weekly chart below clearly reflects the inverse relationship.

With this in mind, we need to recognize that the strength of the U.S. Dollar has been largely influenced by the uncertainty in the Euro. The European Central Bank decision to launch a U.S. style quantitative easing program forced a continuation lower in the Euro. However, in spite of the recent Greek elections and the looming threat of a Greek exit from the Euro-zone, it appears as though the Euro has priced in the threat.

My expectation is that the Euro is due for a retracement, and while we are not likely to see a change in the longer term down trend, we should see traders covering profits and short-term bulls jumping in and buying the up-swing. This will force the U.S. Dollar lower as a reciprocal currency. As the U.S. Dollar retraces lower, we should see a jump in commodities and more to the point of this article, oil. Traders have been benefiting on the short side of oil. As it becomes more evident that a short term bottom may be in place, there will be a period of short covering, which I suspect has already started. Short covering involves the buying back of the short position, which creates demand and influcence prices higher. This can often be a very volatile process.

The challenge is that with so much uncertainty in world of geo-politics and the currency wars raging on, calling a short term bottom in oil is like trying to catch a falling knife and I would add, a slippery one. However, the business of trading and investing is all about risk and reward. It is impossible for us to predict where the exact bottom of oil is but if we believe that there is the potential for a move higher, taking a decisive stance at current levels may yield an attractive return. Over the near term we can look at using a call option to gain exposure while limiting the risk to a defined amount if we are wrong.

HOU is the Horizons BetaPro Nymex Crude Oil Bull Plus Fund ETF. This Exchange Traded Fund provides the investor with a 200% exposure to the daily performance of light sweet crude oil futures. Now, this is a leveraged ETF which means that it can be volatile both in potential gains and potential losses. For more details on this product you can visit the Horizons BetaPro Nymex Crude Oil Bull Plus Fund ETF info page.

Using an 8 and 21 day Exponential Moving Average we can see that the prices of the HOU are starting to consolidate above the lines. This is something we have not seen for quite sometime. It is an indication that there is a potential change in trend taking place.

To take a “shot” at a continuation to the upside with a limited and identifiable risk exposure, you could consider a June $10.00 call on TSE:HOU for $1.70. With the shares currently trading at $9.55, this would be an at-the-money option. This move higher could happen over a much shorter time horizon. However, given the volatility and uncertainty of the oil market, allowing for several months for the trade to play out offers the trader a certain level of comfort.

Keep in mind that this is not a “buy and hold” type strategy. As the shares of TSE:HOU move towards the $15.00 range, it would be appropriate to consider locking in profits. This approach offers the active investor a way to take a decisive stance on a move higher in oil, with a limited and denifiable risk exposure and without limiting profits