From the March 01, 2009 issue of Futures Magazine • Subscribe!

Managing crude volatility with ETFs

Since hitting record highs last summer, the price of crude oil remained volatile as many consumers cut back on their spending, causing demand to drop rapidly and inventories to increase. There are many traders who think the OPEC production cuts will help return prices to high levels once again. However, the reality is that crude prices are in a major downtrend and recent volatility continues to cause wild price swings. This has resulted in many oil-related exchange traded funds (ETFs) trading in the same fashion as the commodity. Is this a sign that crude prices are forming a bottom or is the commodity having a bear rally that will only fizzle out with a continuation in the downtrend?

ETFs are a more conservative way to trade crude. However, the pricing and timing for this type of trading requires that you be watchful of the “catching a falling knife” scenario. You can avoid that with a strategy of playing the range to enter long positions at the bottom of the range and short positions at the top of the range where you can place tight stops on either position and be ready for a breakout if it occurs. The different oil and energy ETFs provide variety and capture a different level of the volatility in the underlying. Here’s a look at two of these ETFs:

U.S. Oil Fund (USO): This fund tracks the price movements for the spot price of West Texas Intermediate (WTI) light, sweet crude. It invests in the WTI contracts, as well as other oil futures, gasoline, heating oil and anything that is petroleum based. Since hitting a 52-week high of $119.17 back in July, the price has been in a major downtrend, recently hitting long-term support at the 52-week low of $27.73. It did this on Dec. 26 with an increase in volume.

Since that time, the fund has been in a trading range between the 52-week low and $38.75. The Stochastics show that shares are oversold but the Relative Strength Index (RSI) does not confirm this. The fund is trading below its declining moving averages. This means that the trading range of USO should continue for now. The Stochastic showing oversold conditions and an increase in volume is encouraging because it is able to hold key support. A key level to watch is $38.75. If there is a clear breakout along with an increase in volume, shares could trade even higher. But if you see the price touch this level, then drop along with little or no increase in volume, it is time to take profits with USO failing to breakout of a key resistance level.

Energy Select SPDR (XLE): This ETF invests in oil and gas as well as energy and equipment stocks. Since hitting a 52-week high of $91.42 on May 24, this fund has been in a severe downtrend, touching the 52-week low and support of $38.83 on Oct. 10. After hitting support, XLE has been trading in a range of $38.83 to $53.30. While the volume has dropped, it is picking back up. The Stochastic and the RSI are showing that the price is not oversold or overbought. It is trading below two declining moving averages while the 50-day moving average is showing signs of flattening out.

What all of this is saying is that since XLE was able to hold support, the 50-day moving average is flattening out and there is a slight increase in volume that a trading range is in place with resistance at $53.30. The neutral conditions from both the Stochastic and the RSI make this a better candidate for a range trade than the USO. While no major breakout has occured, the recent weakness allows you the opportunity to make short-term profits on the volatility.

The best play is to enter a short position above $49 with stops just above resistance at $53.30 on a close-only basis. Take profits at $44 and enter long positions below $42 with stops just below the $38.83 support level. These are low-risk trades that can be executed several times before an eventual breakout occurs.

Watch the key support and resistance levels for a possible breakout. If $53.30 is taken out, it is possible shares could test $63.25. You need to go back to 2005 to find the next level of support below $38.83 but make sure any breakout is accompanied by increasing volume before you pull the trigger.

Oil ETFs are a conservative way to participate in the up and down moves that accompany this volatile commodity.

Chris Seabury is a freelance writer and independent trader. Reach him at associatep@gmail.com .

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