Some firms, including BlackRock, are telling clients that the recent bounce in oil prices indicates that an extension is already priced into the market.
UBS isn’t so sure. The Swiss bank is telling clients to consider a side-door trade than simply taking part in one of the world’s most crowded trades.
Julian Emanuel, a UBS derivatives strategist, said energy shares have closely tracked oil prices in recent years but seem to have disconnected this year from the historical trend. Oil is priced around $50 a barrel, but the Energy Select Sector SPDRexchange-traded fund (ticker: XLE)—comprised of major energy stocks like Exxon Mobil (XOM), Chevron (CHV),Schlumberger (SLB), and ConocoPhillips (COP)—has not participated in the snapback rally.
In fact, XLE, at a recent $68, is priced toward the bottom of a 52-week range that has seen the ETF trade from $64.11 to $78.45.
Emanuel is advising clients to buy the Energy Select Sector SPDR’s June $69 call options that expire June 30 in anticipation that the ETF will pop higher on the OPEC news.
While the trade is intriguing, it is a bit of an outlier. Deutsche Bank, for example, is warning clients that the very companies favored by UBS could come under pressure if OPEC fails to reduce production.
To be sure, many investors are concerned about dividend payments. If oil prices are unable to consolidate some of their recent gains—and preferably advance—because OPEC reduces production, some of the market’s most attractive dividends could be in danger. Exxon Mobil, for example, pays an annual dividend of $3.08, which equates to 3.76% yield.
The dividend risk is mitigated, to some degree, by using options. Anyone who uses options as proxies for stocks risks less money than buying shares.
“With stocks moving more vigorously both higher and lower at any time since before the Nov. 8 election, limited downside/unlimited upside call options appear attractive as premiums remain near the lows,” Emanuel wrote in a recent note.
The point is one we have made many times in the recent past. When options volatility is low, as it is now, investors can buy options without paying the usual fear and greed premium that otherwise constitutes a major part of options prices.
If investors knew what OPEC would decide, the risk of the trade would be substantially less. It makes sense to speculate on the event with options contracts to limit losses without giving up the chance to maximize profits. Already, investors are using this risk-adjusted approach to wager on OPEC’s outcome.
When the VanEck Vectors Oil Services ETF (OIH), for example, was trading around $27.86, an investor bought 10,000 May $28.50 calls for 38 cents that expire Friday—the day after the OPEC meeting. That expresses a view that the ETF shoots above $28.88, basically bouncing off the bottom of its trading range. OIH has traded from $26.10 to $36.35 over the past 52 weeks.
The OIH trade is notable for its size, but it is not a bold trade. What it shows is that institutional investors do not see any merit in trying to be heroic ahead of the OPEC news. They are limiting risk and trying to maximize profits by using the natural leverage inherent in options trading.
If XLE moves sharply on positive OPEC news, the call will increase in value. At $72, the call is worth $3. Should OPEC opt to halt production cuts, this trade is a likely bust, but investors would only lose the amount of money spent on the call. In other words, the XLE trade is a low-cost, potentially high-return trade.
According to Bloomberg, positioning by specs in the long bond is the highest it has been in 10-years:
There are lots of good rationales for being long bonds:
1) The US economy is slowing as seen in the 2s vs 10s yield spread tightening; i.e. the flattening of the yield curve. [US dollar index overlay is the purple line.] Thus, the Trump Reflation trade is dead and the completely revesal proves that, as you can see in the chart below.
2) Inflation expectations are tumbling. Again this can be seen in a chart via Bloomberg below.
The jury is still out on the Fed. They cannot afford to be aggressive with the US and global economy still sluggish and at the same time reduce the size of their balance sheet.
All of that makes a lot of sense. But, there are other rationales that suggest betting against his oneway bet may be worth the risk.
Maybe our narrative is nonsense; nothing more than the usual “talking our book,” so to speak.
However, we like the fact if we are wrong we know where our risk is. But if we are right, we don’t’ know how much our profit might be in this trade. We kind of like those types of bets.
The Dow Jones Transportation Index is having a solid week with a 3% gain over the prior five sessions which began with last week’s kiss off the 200-day sma. The last time the index touched this widely followed sma was in August 2016 when it acted as reliable support within the early stages of the strong post-Brexit rally. After that post-Brexit rally which gained 37% to its March 1 highs, the Transports this time find themselves in a minor downtrend of lower highs and lower lows. And this recent five day winning streak is now running into a number of minor and intermediate levels of resistance.
Starting with the moving averages, the 50-day sma is immediately above at 9,066 while the 100-day sma is just 1.6% away. Splitting those two levels of resistance is the declining trendline connecting the March and April highs. Then you have the ~9,044 level which was a minor resistance in November but has since acted as minor support on numerous occasions in 1H’17. How this industry’s chart resolves could provide a good indication on the current state of the US economy. This Friday is the first revision of the Q1 GDP estimate which initially came in at 0.7%.
Economists on average are looking for a revision higher to 0.9%. GDP however is a lagging indicator and investors are certainly more focused about Q2. The latest forecast out of the Atlanta Fed is for 4.1% GDP growth however the next revision is Friday, May 26th and as we saw in Q1 there is certainly a chance for a string of reduced estimates over the remaining weeks in the quarter.
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