Thursday, October 16, 2008

Texas Tea Proxy Plays

Yesterday I mentioned that crude is projected to continue dropping before settling somewhere in the $45-$60 range. Crude fell to just under $74 at the close yesterday and today the price has dropped another $4 to just under $70 (at the time of this writing). The profit window on this trade is closing as we speak, so without further ado, here's a few recommendations for your consideration.

The pure play on oil
The true pure play on oil is shorting the futures. As many of you out there don't know how to trade futures and might not have the money nor are inclined to take the risks associated with futures trading, I set out to find the best proxy for an oil futures trade. I thought that buying the DUG, the ultrashort* oil and gas ETF would be the play, but that is NOT a pure play. According to this link, the DUG is based on the Dow Jones US Oil & Gas Index (symbol: DJUSEN) which “measures the performance of the energy sector of the U.S. equity market. Component companies include oil drilling equipment and services, coal, oil companies-major, oil companies-secondary, pipelines, liquid, solid or gaseous fossil fuel producers and service companies.” This is why its price movement isn't always inversely correlated to the price of oil. [FYI: The DIG is the ultralong version of the DUG, and the DDG is the short version of the DUG.]

So, is there a better proxy we can use? Well, if there wasn't, I wouldn't be writing this. There are several ETFs out there that track some type of oil futures:

OIL: Ipath ETN Crude Oil: Tracks the Goldman Sachs Crude Oil Return Index (plus treasuries).
DBO: Powershares DB Oil Fund: Tracks the Deutsche Bank Liquid Commodity Index - Optimum Yield Oil Excess Return.
USO: United States Oil Fund, LP: From MSN Money: “The investment seeks to reflect the performance, less expenses, of the spot price of West Texas Intermediate (WTI) light, sweet crude oil. The fund will invest in futures contracts for WTI light, sweet crude oil, other types of crude oil, heating oil, gasoline, natural gas and other petroleum based-fuels that are traded on exchanges. It may also invest in other oil interests such as cash-settled options on oil futures contracts, forward contracts for oil, and OTC.” A weekly chart of USO is at the bottom.

These are the pure oil plays. Their charts are fairly interchangeable, and they've all lost 50% of their value since their all time highs on July 11th. My top choice is the USO because it is by far the most liquid of the group with an average daily volume over 13 million shares. The trading volume on OIL is around 800,000 which isn't shabby unless you're playing options, and there USO is the clear winner.

Stock and options plays
I think shorting the USO anywhere under $58.00 with a protective stop at the $62.00 resistance level is a good play. The next major area of support is around $55. If it can't break through that (but I do think it will), then cover your position or protect it with a call option (see married calls below). When it gets below $56, start setting trailing stops. [One popular method is to set the stop at the previous day's closing price plus the average true range which is about $4 for USO.]

Because of the high VIX, I urge you NOT TO BUY OPTIONS unless they are part of a spread. Seasoned options traders can take in premium by using covered puts, calendar put spreads, and bear-call credit spreads. Because of the extreme market volatility, I suggest avoiding the latter unless it's an out-of-the-money spread. Though your loss is limited, you still can easily incur one for an at-the-money call spread, and who wants that?

The novice options trader should look to bear put debit spreads instead of buying a straight put as the spread mitigates the effect of volatility-inflated premiums. Married calls can also be used. One big advantage of this strategy is that the call limits your loss should the stock rise in price (which it could well do in this volatile market climate).

I don't have room to go into each strategy in detail; these are merely suggestions for further consideration. As always, know what you're doing before attempting to trade any of them. Since we're in a bear market and are likely to be in one for some time, you might wish to add some of these to your trading arsenal--but paper trade first!

Other related ETFs
OIH, FXJ: Both are plays on the oil services sector.
DBC: A diversified commodities ETF.
XLE: Oil and gas companies ETF.

Note: You can see from this discussion how important it is for you to thoroughly research your prospective ETF purchases so that you will have a better understanding of the factors influencing their price movement.

Weekly Chart of the USO: US Oil & Gas Fund
(Click to enlarge.)

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