XOP ETF: Buying Into This Upmove

Intro

We recently got long once more SPDR S&P Oil & Gas Exploration & Production ETF (NYSEARCA:XOP) through the use of call debit spreads. We believe the ETF has once more bottomed so we are investing once more with the fund’s trend of higher lows. More aggressive traders tend not to spread out their positions (due to the defined risk element of spreads over naked options which can lead to lower returns). However, spreads have many advantages, especially for new traders looking to get their feet wet in options trading.

The way we set up our positions is by buying one strike in the money and then selling a subsequent call option out of the money. Our aim is to have both strikes equidistant from the prevailing share price of the ETF/stock. Suffice it to say, if XOP can rally from its present level ($141.70), the in-the-money call option will increase in price faster than the sold call option. The benefit of call spreads over buying XOP call outright is that a $5000 investment for example in at-the-money calls is far more volatile than a $5000 investment in at-the-money XOP call spreads. Yes, the potential gain of the naked calls may not be capped but this strategy demands far more attention especially if the position was to go against you. Suffice it to say, we prefer to stick with spreads as it enables us to sleep at night and takes any anxiety out of the equation. On this note, here are two reasons why we like Oil & Gas Exploration & Production ETF on the long side at this moment in time.

Symmetrical Triangle

This pattern depicted below usually plays itself as a continuation pattern which is bullish for XOP considering its strong move out of its 2020 lows. This means the pattern should point to consolidation before resuming its next move upward. The advantage of these types of patterns is that they have a time component embedded within them (Due to the two converging trendlines) so we will get confirmation on the fund’s long-term direction sooner rather than later. For now, though, we have another convincing MACD crossover which took place on a further higher low. Moreover, similar to previous lows, we have had strong buying volume take place once the swing low was confirmed. Shares of XOP have had an excellent start to the year (Momentum-wise) easily outperforming other ETFs on average.

Low Implied Volatility

Although the options trading industry sells the benefit of consistently selling option premiums in high implied volatility environments, buying volatility (When it is down at bargain basement levels) can be just as attractive. Many traders who solely focus on option selling point to theta decay to justify their trading strategies. Their reasoning here is that all options at expiration are void of any extrinsic value. While this may be true, the other greeks (Especially Delta) can quickly override any advantage theta may be provided in a position at any given time.

Suffice it to say, we want to be buying our debit spreads when XOP implied volatility is well below its 52-week average. As we see below, XOP’s current IV comes in at a very low 36% so there can not be much room to the downside here from an implied volatility standpoint.

Why is this important? Well, by understanding that low implied volatility in XOP means options are underpriced, we can manage this trade both from a delta standpoint (direction) as well as vega (volatility). If implied volatility were to spike from its current level for example but we failed to get the directional move we wanted, we would be more inclined to NOT let this trade run until expiration for the following reason. Implied volatility is mean-reverting whereas price is obviously not. Therefore, our actual edge in this setup (When using options spreads over shares of XOP) is actually in the volatility element of the spread. Therefore once IV reverts back to somewhere near its average, the possibilities of more sustained increases in the prices of the call options begin to wane from that point.

Conclusion

Therefore, we will see how this position plays itself out over the next 30 days or so. If we can get 90% of the value of the spread ($180 per spread), this would be a very nice return over a 30-day period. Let’s see what unfolds. We look forward to continued coverage.