Year-to-date, the Energy Select Sector SPDR (ETF) (NYSEARCA:XLE) is down 10%, but of late it’s has a nice rally. So am I too late betting bullish XLE at these levels? No. Today I am betting that there is an opportunity to profit on the bullish side of it and with no out-of-pocket risk.
Not every trade fits well in every portfolio. This one tucks in nicely in mine as I have been long Exxon Mobil Corporation (NYSE:XOM) stock, but recently booked my profits.
XLE trades inline with the energy equities. Specifically XOM and Chevron Corporation (NYSE:CVX), as they constitute almost 40% of the exchange-traded fund. Schlumberger Limited. (NYSE:SLB) ConocoPhillips (NYSE:COP) and EOG Resources Inc (NYSE:EOG) make up another 16% of the XLE.
The risk of committing long XLE is that most of these companies have been in breakouts for weeks, so they could be due for a dip. For example, CVX is now 13% higher than late August. So timing may not be ideal but that’s why I use options to build a buffer just in case.
Fundamentally, XLE component companies are no longer cheap, so market-timing could become an issue. Long term, they are the likely winners in the sector, but that is no comfort from the stock entry precision perspective. There are likely to be better entry points.
However, it is important to note that with today’s write up, I am not chasing the XLE rally this late in its cycle. Instead, I am betting that prices will hold for a bit longer.
There are two aspects of this energy price rally that I believe will continue to lend support to oil stocks and XLE.
First, the situation with the tensions between the U.S. and Iran. Rhetoric is ugly and not likely to end soon. So the added premium in oil prices is likely to persist a bit longer.
Second, the world is anticipating that OPEC, mainly Saudi Arabia will want to keep oil prices propped up until they execute the initial public offering of their state oil company. Higher oil prices will likely mean higher stock IPO price release.
Special circumstance aside and left on its own, oil prices are limited at these levels. OPEC will rapidly lose market share to the west if prices continue to rise. But for now, the aforementioned reasons should keep us hovering above $50 per barrel for a few more weeks. And therein lies my opportunity.
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Today I am selling downside risk against the support that these situations created. Time will do the rest as premium decays in my favor as time elapses. But if my thesis is wrong then I must own XLE shares.
The Trade: Sell Dec XLE $65 put and collect 70 cents per contract to open. Here I have an 80% theoretical chance that prices will hold above my strike so I can retain maximum gains. Otherwise, I accrue losses below $64.30.
Selling naked puts carries a big risk. For those who want to mitigate it, they can sell a spread instead.
The Alternate Trade: Sell the Dec XLE $65.50/$63.50 credit put spread where I can yield 25% on risk. Both trades have about the same odds of winning but here I have limited risk.
Ultimately, regardless of how careful I am, investing in stocks is fraught with danger, so I never risk more than I am willing to lose
Learn how to generate income from options here. Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities. You can follow him as @racernic on twitter and stocktwits.
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