Bellybuttons and Zeroes (FXI ,XOM, XLE)

Before we start this week’s rant, let’s take a minute to close out a successful trade.

It’s actually two successful trades that are one and the same.

The first was opened on the 8th of December in a letter called Chinese Market Riddle – Solved! The second was launched just three weeks later in China Breakout Imminent. They both involved option sales on the iShares China Large-Cap ETF (NYSE:FXI) and the lowdown follows –

lowdown

There wasn’t a great deal of difference between the two trades – neither in our reason for initiating them nor in the technical setup surrounding them. But what’s happened since then indicates to us that we should pocket the great big ball of cash that they’re offering before anything happens.

Before we get to the details of the trade, however take a look at the technical structure of the stock.

fxi11215
We like the looks of FXI’s RSI and MACD indicators, both of which surfaced above their waterlines roughly two months ago. We like the steady climb of the moving averages, too (fully unfurled and trending higher), which speak to ongoing strength in the stock, as well.

What concerns us, though, is the stock’s return to the $42.50 level, the point at which a massive, four-year resistance develops and at which on at least six different occasions FXI failed to punch higher.

And our question is – will she be rebuffed again?

scorned

We don’t know.

But we do have cash in hand, and it looks like an opportune time to take it, considering a pullback from $42.50 at this stage could eat into our gains appreciably.

Here’s the Numbers

 

On December 8th we said support at the moving averages in the 37-range was strong (and we still believe it the case). We therefore sold ten FXI February 37 PUTs for $0.38 each, for a total credit of $380. Three-weeks later we pulled the same stunt. We sold another ten February 37 PUTs for $300. Our total take at the outset was $680.

And today, the February 37s are trading for just $0.10. Buy back all 20 for $2.00 and your net profit is $480 on a $200 investment, or a return of 240% in a month.

Nick-nack-paddy-WHACK!

whip

OUCH!

 

Hurts so good.

ON WITH IT!

We’re going to continue our options seminar series today with a discussion of one of our favorite of all bets, the ZERO Premium options trade. It’s called ‘zero premium’ because it costs nothing (or next to nothing) to initiate.

And it works like this –

We buy an option and sell an option for the same price, creating a net zero outlay.

Simple, no?

That’s the skeleton of the thing, but the meat of the matter is far more interesting.

And it goes like this.

We have two securities from the same sector (usually), or two ETFs representing two different sectors (often) or two completely unrelated and randomly selected securities (rarely), one of which we believe will outperform the other over a certain time period.

For example, we might look at a chart that pits Exxon Mobil (NYSE:XOM) stock against the oil production sector represented by the Select Sector SPDR Energy ETF (NYSE:XLE) and see that, indeed, XOM has outperformed strongly over the last three-months.

See here –

xlexom15
The chart makes it clear. Exxon Mobil’s outperformance over her peer group is gathering strength as time passes – as indicated by the widening gaps in blue. At the same time, the volume surge evident as XOM bottomed speaks to a rebound in price – as do the RSI and MACD indicators (in black), the latter about to confirm the former’s rise above her ‘waterline.’

We see nothing material, either, in the current fundamentals for Exxon Mobil that would indicate the outperformance is now about to end. On the contrary, the pullback has made XOM shares even more inviting, sporting as they now do an annual dividend yield of 3% and a P/E ratio of just 11.59. Those are great numbers for one of the world’s largest companies by market cap and one whose asset base nay be the most diversified on the planet.

So What Happens Next?

 

For the ZERO premium trade to work, we simply have to select either CALLs or PUTs on the securities in question, then buy and sell them. It doesn’t make so much of a difference which, only that we buy and sell the right ones.

In this instance, we might be wise to choose CALLs, because when stocks are in a downtrend they tend to fall in an erratic manner, and even though XOM has outperformed of late, we might see her play ‘catch-up’ (down) should the bear move continue.

So we’ll select the CALLs, and in the event we’re wrong and both keep falling, at least they’ll both close far out-of-the-money, and we won’t be forced to buy or sell anything we don’t want.

On the other hand, if oil rebounds, we’ll likely see XOM continue to outperform the broad oil sector.

So if we buy CALLs on XOM and sell them on XLE, and they’re both roughly the same price, we’ll a) pay nothing to launch the trade, and b) see a profit if/as/when XOM rises more rapidly than XLE.

On the other hand, even if XOM drops less rapidly than XLE, we’ll also cash in nicely on the trade. Any outperformance on Exxon Mobil’s part will lead to a gain on the trade.

cheer

Finally, a word on quantifying profits with a zero premium trade.

What is your gain if you spend nothing and come home with $100 or $1000, or, indeed, any amount?

It’s really not possible to do so.

Let’s create that problem.

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Wall Street Elite recommends you consider 1) closing down your FXI PUTs as detailed above and 2) buying the XOM March 100 CALL for $0.59 and selling the XLE March 86 CALL for $0.54 for a total debit of $0.05 per pair traded.

 

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Wall Street Elite recommends you consider 1) closing down your FXI PUTs as detailed above and 2) buying the XOM March 100 CALL for $0.59 and selling the XLE March 86 CALL for $0.54 for a total debit of $0.05 per pair traded.

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With kind regards,

Hugh L. O’Haynew, Senior Analyst, Normandy Research

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