XOP: High Implied Volatility, 22% Yield

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Binary Tree Analytics
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Summary

  • The SPDR S&P Oil & Gas Exploration & Production ETF provides an investor with access to the US medium and small size oil and gas producers.
  • XOP has recently sold off the highs on the back of the new Covid Omicron variant which caused market participants to re-think the robustness of oil demand.
  • We believe XOP is in a multi-year uptrend that is going to test from time to time the lower bound of the channel.
  • A savvy investor can make a 22% annualized yield or own the stock at a 14% discount by entering the proposed trade.

Rise in gasoline prices concept with double exposure of digital screen with financial chart graphs and oil pumps on a field.

peshkov/iStock via Getty Images

Thesis

The SPDR S&P Oil & Gas Exploration & Production ETF (NYSEARCA:XOP) provides an investor with access to the US medium and small size pure oil and gas producers. This ETF has a high correlation to the price of oil but more importantly it represents a clean play on oil prices since the underlying constituents make money out of extracting oil and selling it for a price higher than the production cost. A more muddled take on the price of oil is investing through the "Majors" represented by the likes of Exxon (XOM), Chevron (CVX) or BP (BP) - the issue with these very large corporates lies in the vast refining, petrochemical, transportation, trading and retail operations they run, which decreases the correlation with oil prices to a larger degree. XOP has recently sold off the highs on the back of the new Covid Omicron variant which caused market participants to re-think the robustness of oil demand. We believe Omicron is just one of the many variants that will appear down the road but does not fundamentally alter a landscape where the world has learnt how to cope and live with Covid and is continuing a strong vaccination drive which decreases hospitalization rates. Covid is here to stay for a few years and new variants will flare up from time to time causing the markets to be nervous and volatile. The world is re-opening and moving to a new normal where we will see for decades to come people wearing masks in airports, and oil demand will return to pre-Covid levels once winter is gone. Large investment banks such as Goldman are re-iterating their call for oil at $100 even as the market sells off. We believe dips are to be bought in XOP, but more interestingly and conservatively we advise to take advantage of the very high implied volatility in the XOP option chain to gain exposure to the ETF at a level that can provide an annualized yield of 22%.

Portfolio Composition

XOP is composed of small, medium and some larger E&P producers:

XOP ETF top 10 holdings

Source: State Street Fact Sheet

If we look at the top ten holdings for the ETF we can notice that the top three falls into the small cap size category, while the middle cohort is composed of a number of larger capitalization stocks such as ConocoPhillips. The main takeaway from the portfolio composition is that the companies present in this ETF generally have a very simple Net Income calculation, namely Price of Oil - Cost of Extracting Oil = Net Income. In this sense the forward earnings analysis is much more simplified and generally requires oil prices to stay in a 60s-70s range for these companies to be extremely profitable.

Technical Set-Up

XOP ETF technical analysis

Source: Seeking Alpha

The fund is on an uptrend channel, with the lower bound coming close to a price of $90/share. When a stock is in an uptrend, wait for the price to test the bottom of the channel in order to buy. Buy low and sell high goes the old adage.

XOP buy low and sell high

Source: Seeking Alpha

Above is the same graph where we also overlay the Relative Strength Indicator (*RSI) which is also close to a strong buy signal. As the RSI approaches the bottom of the channel (i.e. a 30 level) it indicates an oversold market that is ready to bounce.

We like the trend, we feel the bottom of the uptrend channel is going to hold and this is a nice technical set-up to enter a conservative trade.

What is the trade?

Instead of buying XOP outright, we think that the recent sell-off coupled with the high implied volatility that the option chain for the stock exhibits makes for a high reward low risk cash covered put trade.

XOP trade

Source: Author

If an investor writes a $90 strike, June 17, 2022 put, the maximum cash out is $9,000 and the premium received is $1,000. That figure is 11% of the maximum cash out, or on an annualized yield basis represents a 22% yield.

Outcome A

* XOP rallies in the next months

* the put expires without being triggered

* an investor makes $1,000 for 1 contract, or better put a 22% annualized yield

Outcome B

* XOP closes below $90 on maturity date

* the put is triggered

* an investor ends up buying XOP at $80/share (strike - premium)

* that price is 14% lower than where spot is today, hence a very conservative entry point

This trade is best to be done with a cash covered component - i.e. the investor entering into this trade should set aside the $9,000 maximum cash out that would be required if the trade gets triggered.

Conclusion

The recent oil sell-off driven by the new Covid variant is a temporary dip. We like the XOP components for their high correlation to oil prices and the direct impact to net income they generate. We believe XOP is in a multi-year uptrend that is going to test from time to time the lower bound of the channel. Dips are to be bought, and for a conservative investor a cash covered put strategy is ideal to take advantage of the high implied volatility. A savvy investor can make a 22% annualized yield or own the stock at a 14% discount by entering the above trade.

This article was written by

Binary Tree Analytics profile picture
2.66K Followers
With a financial services cash and derivatives trading background, Binary Tree Analytics aims to provide transparency and analytics in respect to capital markets instruments and trades._____________________________http://www.BinaryTreeAnalytics.com

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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