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January 18, 2009

Reverse Reverse Course

That was weak, people. I'd like to sit here and type optimistic prose about how equities followed through on Thursday's reversal and kept on course for an imminent meeting with the 65DMA, but I simply don't like the way Friday played out. The early attempt at follow-thru fizzled, and price/volume patterns are not supporting the idea of an assault on higher levels. Therefore, I will exercise one of my fundamental rights as a trader: the right to abruptly change my mind. Quickly flipping sides is not only a right, it is a necessity of survival in this game.

As always, one should be careful not to read too much into opex action, but when I peer at the SPX chart through my magic goggles, I see one of those ominous red bars:

stock index chart

Late Friday, I reapplied my GDX short in the form of short calls. With equity action so weak, I really don't see miners making much headway, even if gold rallies further. But neither do I see gold carrying a jet pack anytime soon. Therefore, I felt safe selling time. I also sold index futures, but only a dabbling lot as I hadn't the time to thoroughly digest the action. Globex does trade tonight, so I may expand my bet, the key word being "may." As is my nature, I incubate ideas as long as reasonably possible before making important decisions.

The price of crude has been discussed frequently on this blog, in particular my opinion that oil will see a large (but temporary) move higher in the near future. However, due to recently high volatility, I have been studying other approaches to profiting from this market. One compelling argument regarding shorting the crack spread was discussed on Seeking Alpha last month. However, anyone who took that bet is now out $2/barrel on a minimum lot of three contracts (to balance the components). Ouch.

My idea is a bit less esoteric. In recent months, the front contract has slipped to a spread of about $5-6 per barrel below the following month's contract price as the front month approached final settlement. My only explanation for this action is that physical oil is being dumped on the cash market as expiration approaches. Considering the glut now on the market, it is reasonable to expect such behavior to continue.

Looking forward three months, one can observe the June/May spread at $1.84. As long as one does not expect oil to revert to backwardation in the next three months, the risk of going long the June/May spread is less than $1.84 per pair, whereas the potential profit is $4-5 per pair. One could always place a spread stop at zero since backwardation would signify a significant change in conditions, but overall, the paired trade seems fairly low-risk. I outline this idea not to urge anyone to enter it, but rather to (hopefully) spur discussion and gather more intelligent thoughts.


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