Tuesday, September 24, 2013

USO: Crude bear play

Update 10/11/2013: USO for a second time bounced off the lower boundary of its 20-day price channel amid a sideways run fluctuating between $36.41 and $37.54 during regular trading hours. It dipped as low as $36.30 in pre-market trading but quickly retreated to the upside.

For the reasons outlined in my post "Time-limited trades", I'm declaring USO to be a slacker lacking momentum and have closed my position.

The net movement in USO's share price over the 10 days I held the position was half a percent, or 2% annualized. My bear call options spread produced a 1.5% yield on risk, or 52.9% annualized.

Basically, it was a wash.

Update 10/1/2013: USO dipped below its resistance, $36.85, in pre-opening trading and remained there throughout the day.

In the last half hour of trading, USO's price ranged from $36.65 to $37.73. Although that range is above the initial price at the opening bell, $36.61, it is below the pre-market open of $36.80 at 8:15 a.m. New York time, and I am treating today's close as sufficient momentum to support a trade.

I opened a bear position in USO at $36.72, structuring it as a bear call options spread expiring in November, short the $37.50 calls and long the $38.50 calls. 

The position has a maximum potential yield of 44.9%. Leverage is 7:1. The position has a 3.2% hedge of profitability above the entry price on the underlying stock.

Update 9/30/2013: USO gapped below the $36.85 downside resistance level before the opening bell but then rose steadily to peak in the third half hour before the close. From that point in declined, but in the last 20 minutes of trading touched the resistance level and treated it as support. That resets the question to where it was on Sept. 25: A break below $36.85 with downside momentum intra-day is a chart I can trade; otherwise, no.

Update 9/25/2013: I've taken a closer look this morning at USO's downside resistance. Tuesday's low, set in the second half hour of trading, was $36.85. 

The peak of trading on Aug. 8 following an downside opening gap was $36.86, and that day's trading was followed immediately by an upside opening gap. The peak of trading on July 9 was $36.80, and it was followed the next day by an opening gap to the upside.

So $36.85 to $36.86 is a very significant level, and a break below would signify that downside momentum had indeed resumed.

USO opened today at $37.29. I'm setting an alert at $36.86. Any move below that level will tell me to resume close monitoring of USO with an eye to opening a bear position in the last half hour of Wednesday's trading.

Update 9/24/2013: USO in the last two hours of trading rose significantly, from $37.05 to a peak of $37.30, and it  stayed trading sideways just below that peak as the closing bell approached. 

Of greatest importance for the application of my trading rules, the rise pushed USO back to the lower boundary of the 20-day price channel, $37.27, and also produced an intraday rise of 1.2%, low to high. That's insufficient downside momentum to support opening a bear position.

I'll add USO to my Watchlist and if downside momentum recovers and produces a fresh break below the 20-day price channel, I'll reconsider the trade. USO is a fund and so there are no complications from earnings announcements to worry about.

Despite the perpetually entertaining headlines about crude oil's rise and fall, the fact is that the price of oil has pretty much gone nowhere since the summer of 2009. The entirety of the commodity's movements since then can be contained within a box from $29 to $44 plus change.

For a trader, oil is a play for the short term. Given some leverage, there is money to be made from its fluctuations, and many major moves, of the sort that make or break fortunes, have happened within the span of a month or a week.

Sideways markets are a profit killer for the unwary trader who attempts to play their fluctuations as directional trends. As soon as the signal is given and the trader hops aboard, like as not the price will reverse, leaving the position with a loss.

Crude oil is tracked by the exchanged-traded USO, the United States Oil Fund LP, whose portfolio consists almost entirely of crude oil futures contracts.

The fund's price dropped below its 20-day price channel on Monday and continued lower today, confirming the bear signal under the Turtle Trading system.

A trader who follows the strict Turtle rules will open a position on the basis of that signal alone. For me, the chart is where the final trading decision must be made, and an interesting chart it is.
USO 5 years 4-day bar

USO, tracking the price of crude, has been executing a descending triangle since May 2011. On June 10 this year the price broke above the upper boundary of the triangle, where it remains today.

Monday's bear signal is a move back toward the upper boundary, which today stands just below $36.50, about 60 cents or so below the present price.

One other fact about the pattern is its size. It is a very big triangle whose apex lies somewhere in the misty distance of March 2016.

What to make of this?

A descending triangle is a bearish continuation pattern, meaning that when the apex is reached, then USO will resume its downward trend that began in 2008 as the Great Recession kicked in.

However, the distance from now to the apex is so great that it is essentially meaningless. The triangle's only value, for my trading, is to provide a framework to constrain the price and guide analysis of its likely future reversals.

When the price breaks beyond a triangle boundary at a time when the apex is still distant, it tends to return to the triangle, and that is what appears to be happening now.

USO's chart shows a tendency for declines from the upper chart boundary to go all the way to the lower boundary, as has happened twice since the triangle began.

If that is indeed what is occurring, then USO has the potential of declining to $29 in the present move, a bearish move of 22% from the current price on the shares, without leverage.

And leverage there is.

USO on average trades 2.1 million shares a day and supports an extremely wide selection of option strike prices at 50 cent intervals and with open interest in the four and five figures. The front-month at-the-money bid/ask spread on puts is 1.9%, which is quite narrow.

Implied volatility stands at 23%, slightly below the midpoint of the six-month range. It has been falling since late August, although it has recovered slightly in an upward move beginning a few days ago.

Options are pricing in confidence that 68.2% of trades will fall between $34.63 and $39.49 over the next month, for a potential gain or loss of 6.5%, and between $35.89 and $38.23 over the next week.

Two symbols survived my initial screening last night. USO was not among them.

Although both survivors, MCP and BELLY, confirmed their bull signals, further analysis today kicked them both off the prospects list. MCP's future is rated bearish by Zacks, and I generally prefer for Zacks and the direction of my trades to be aligned. BELLY has very low volume and is too illiquid for my purposes.

Besides, my holdings are overloaded on bull positions. I need some bear plays for balance. So I looked at high volume bear signals that had not survived last night's screening, and USO was near the top of the list.

It failed to pass initial screening because of low historical odds of a profitable bear trade since the markets began their present trend in 2011. It worked out to one chance of a profit for every four bear signals.

My initial screening, of course, is one size fits all, as it must be in dealing with more than 2,000 symbols. It is in the second and third phases, today, that I took a closer look.

The low odds are exactly what I would expect from a sideways pattern, such as USO's triangle. Trends in triangles are stillborn, as are their profits.

Having broken my rules to take a deeper look at USO, I now as a trader must face the decision: Is this a trade I should take?

Best case, USO descends back into the triangle and continues its merry way down to $29. Big profits and champagne.

Worst case, it stays above the boundary and again challenges its breakout high of $39.54. A loss, followed by soul searching.

Catastrophic case, of course, something really bad happens in the Middle East and the price of crude triples or quintuples, in which case I'm very, very happy that I structured the trade as a hedged options spread, limiting my potential loss.

Putting it another way, and ignoring the catastrophic, it is a choice between a potential reward on the stock movement of 22% vs. the risk of a 7% loss.

Decision for my account: The reward/risk ratio works out to be around 7:1. Those are great odds. The chart provides a reasonable expectation for further movement to the downside.

If USO continues to show downside momentum in the very short term within the last half hour of trading, I intend to open a bear position, structured as a bear call options spread expiring in October. 

I'll update this posting near the close with my final decision.


My trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

I use the number 68.2% in using applied volatility to calculate the expected trading range. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

By preference I place my trades in the last half hour before the closing bell in New York. See my essay "When is the best time to trade" for a discussion of the practice.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

No comments:

Post a Comment