An Intriguing Play on Energy

 | Jun 24, 2014 | 12:16 PM EDT
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My breakout scans today were littered with energy names, and almost all the highest-ranked ones were associated with energy in one way or another. I thought to myself, "Self, surely there is too much heat right now. A fade of some sort must be the play." So I pulled up the daily chart of the Energy Select Sector SPDR (XLE) and began my analysis.

XLE -- Daily

If I look at the trendlines from mid-April, the change in slope is obvious. The line went from flat to 30 degrees to 45 degrees in just two months. The ETF has held its eight-day simple moving average well, and it hasn't sniffed its 21-day SMA since June started. It doesn't end with the price move, though.

Secondary indicators, such as the relative strength index, are still in overbought territory and pulling back a bit. The same can be said about the commodity channel index (CCI), as well as the money flow index (MFI), and all the while volume is fading as the price moves higher. Surely these are bearish indicators. My first thought would be to look short via puts or put spreads, or perhaps a diagonal put spread.

As I looked back through 2012, I didn't really see this exact pattern on the daily chart, so I expanded to the weekly charts -- and that's when I found something interesting.

XLE -- Weekly, 2010 vs. 2014

When I look at the XLE's weekly chart back to the last quarter of 2010 and compare it to the current weekly setup, I find a very similar look. The chart holds basically all the same characteristics now as it had done back then. In 2010, volume expanded, per the Bollinger Bands, as the price was breaking higher. This came from a point where the Bollinger Bands were contained inside a more conservative Keltner channel. Furthermore, RSI was rising and pushing above 70, as was the MFI. In both cases, I also found the big separation between the eight-week SMA and the 21-week SMA.

The uptrend in late 2010 did not end until the eight-week SMA was broken. If we run a comparison to where the numbers stand right now, that means another three months of rallying and a further climb of 15% to 20%. I have a hard time believing that will happen -- but before we short the fund outright, it seems the best thing to do is to wait for the eight-week SMA to break.

If I were to do anything here, I would consider a fairly deep in-the-money calendar put spread or diagonal put. While this seems counterintuitive, the move would define and limit risk. For instance, I could look at buying the December $108 put and shorting the September $106 puts for around $3. If the fund were then able to rally for a few more months, the September $106 put could be worth very little as it comes into expiration. Then, if XLE reversed as it did in 2011, the December put could do very well. If the price fell off a cliff, there would be $2 intrinsic value in this spread, so my worst-case loss would be $1.

With this trade, I would carry the risk of the XLE rallying very, very hard, as such a move could cause me to lose all $3. But XLE may have to rise quite a bit in order for that to happen. I estimate that, if XLE rallies to $110 by September expiration, the December put will still be worth around $2.50, so the loss would be minimal there. It would likely take a rise above $120 in order to wipe out most of the value of this position. I'd prefer to wait a day or two and see how XLE acts before I make a move. But I do like this concept quite a bit.

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