A Crude (but not Vulgar) Pairs Trade (USO, OIH)

We keep a close eye on oil prices because they’re possibly the premiere bellwether indicator of both financial and economic strength.

And today we’re watching them particularly closely.

For a number of reasons.

Remember – during the market meltdown of 2008 oil prices served as a leading indicator for the stock market. After climbing to $150 a barrel in mid-summer of that year, crude oil began to decline, gathering momentum well in advance of the swoon that stocks incurred as the kids went back to school in the fall of 2008.

Look here –

spxuso

This is the United States Oil ETF (NYSE:USO) charted against the S&P 500 from the top of the market in the spring of 2008 to the bottom of the bear a year later.

And the picture is a clear one – oil began its decline two full months ahead of the S&P’s dive in late September/early October of that year (in blue).

Oil also bottomed before the equity market did in the winter of 2009 and volumes from the crude pits were extraordinarily reliable as a bottom marker for both asset classes (as seen in black).

To put it simply, we have a great deal to learn from inter-market technical analysis in general, and from the oil/equity relationship in particular.

ginger

While it may be macho to say that we’re hot on oil or biotech or gold or health care, in today’s market we’re not so keen to do so. The financial times we’re traversing are confusing in the extreme, so it makes much more sense to us to’ relativize’ our likes and dislikes, and we do that by matching them against other sectors or asset classes. For example, we prefer to say that we like the retailers over the telecoms, or the internet stocks more than the broad market. But to make an absolute bet on any sector at this stage is simply not a wise approach, in our view.

Why?

Because we could very easily find ourselves in the middle of a sharp correction at any point in the next few weeks or months (Lord knows we’re overdue for one), and taking a big loss on a straight long position is simply not worth it. Making relative bets is just a far safer strategy.

And so it is with oil.

That is, we see in crude a commodity on the rise, as evidenced by higher highs and higher lows (see chart below), though it’s certainly not an investment without its risks.

Take a look –

uso

USO’s chart presents a classic bullish formation, with higher highs followed by higher lows in an upward lurching zigzag (red circles). The latest decline to the 137-day moving average is also a green light for the stock (last red circle). A healthy move higher should return to touch the 137 DMA every few months.

Note, too, that the longer term MAs are all moving higher, and that price is not trending at an extreme distance from any of them.

We also like the volume bulge we saw with the last decline, as it speaks to a climax, however limited, in the most recent bout of selling.

And finally, RSI and MACD indications (in blue) are both constructive. RSI has just poked its head above water, and MACD has crossed higher. It’ll take another week of positive motion on the stock to pull MACD fully above its waterline, thereby confirming RSI’s break and putting us squarely into a bullish posture, but in the meantime the seeds of the next move higher are being sown.

Takeaways:

Oil looks moderately strong, and will likely push to new highs in the next six to ten weeks.

‘Relativizing’ the Trade

As we stated above, we don’t believe it’s wise to go straight long at this stage unless the move is a slam-dunk, and oil is plainly not a slam-dunk long at present. But paired against a super-hot oil services sector, we think, we may afford us an opportunity to transact some healthy business.

Here’s a chart of the Market Vectors Oil Services ETF (NYSE:OIH), a stock that got a little too hot in the last few months.

oih

RSI indications a month ago went above the overbought 80-level (in blue) and MACD also rolled over, giving us a negative divergence with price (in red).

The stock also looks like it’s having difficulty with resistance at 58, and for all of the above, we believe oil, the commodity, will outperform its associated service sector for the next three months.

Here’s a chart of the two matched against each other –

oihuso

There’s no question, the oil services community got overbid and is now correcting.

Buying six month OIH PUTs and selling six month USO PUTs looks like a good prospect to us.

Many happy returns,

Matt McAbby, Senior Analyst, Normandy Research

See what people are saying...

  1. josh

    Matt:
    Are there some fundamental reasons that align with your technical analysis supporting your hypothesis that an increase in the price of oil will not coincide with an increase in the oil services? What dynamics need to be expressed to have oil increase while the finite capacity of the drillers and service providers would decrease?

    I am an industrial metals trader (both physical and futures). When there isn’t a similar coincident rise in the analogous sectors in my market there is usually a specific fundamental thesis being expressed. While all markets are different, I’d love to get your feedback. The “why” is an important part of the puzzle which can help one quantify the strength of one’s convictions.

  2. Jim Van Steenbergen

    How do you trade the USO and OIH combination? Thank you for your response.

  3. Dan

    I like this pair, But what I don’t like is the way the premiums line up for the 2 underlyings.

    Looking at Jan 2015 put options.

    USO – 36 P for .93

    OIH – Im actually looking to do a put spread because the prices are so much higher.

    55-51 Put spread for 1.15

    51.15 is the 137 day moving average for OIH

    Any thoughts?

  4. Ami

    hello, some time ago you recommended the purchase of long dated calls on TBT, which declined much thereafter.
    I saw that between 29 Mai 2013 and 21 July 2014 TLT came back to the same price while TBT was down 15% at that period.
    what do you say about that? anything you recommend with regard to the long TBT calls?
    thank you