Overlaps could be the way to play off mixed signals from the oil sector

On Tuesday, June 5, crude oil registered its first impression below $100 a barrel since May 11, sending black gold to trade at its lowest level since March. To add insult to injury, oil and gas stocks are entering a historically bearish month and quarter. Is there a silver lining to be drawn from the energy sector right now?

Each month, Schaeffer’s senior quantitative analyst, Rocky White, compiles a list of the 25 worst performing stocks in the S&P 500 Index (SPX) over the past 10 years. According to the chart below, oil and gas stocks are made up of nine of the 25 worst performers for July. This includes heavy hitters like Exxon-Mobil Corp (NYSE: XOM), Occidental Petroleum Corporation (NYSE:OXY)and Marathon Oil Corporation (NYSE:MRO)with respective average losses of -2.6%, -3.9% and -4.6%.

White compiled a similar list for the third quarter of the past decade. There are six oil stocks on the list, the most of any sector by a wide margin. Notable names below include Chevron Corporation (NYSE:CVX), with an average quarterly loss of 3.3%, with only three positive quarters in the past 10 years. It’s a similar story for the VanEck Vectors Oil Services ETF (NYSEARCA:OIH)which averaged a loss of -1.9% in July and a deficit of -6.2% in the third quarter, historically, over the last decade.

Cautious contrarian investors – especially in options trading – should of course not rely solely on seasonal quantitative analysis. Context regarding historical volatility is key. Prior to this summer’s technical breakdown, oil and gas stocks had mostly been spared the brunt of the 2022 selloff. Another study compiled by White offers a way for options traders inclined towards oil stocks to potentially take advantage of a period of downside seasonality.

First, White created hypothetical call and put options that are exactly at the money and expire in exactly 21 trading days. The table below then takes real options to get an implied volatility for those hypothetical options, and with that we can find the prices we can expect those options to trade at. Using these hypothetical options, let’s assume a trader has bought a straddle on each symbol (thus buying the call option and the put option). Next, we look at the returns a trader would get if he bought one of these straddles each day and held it until the hypothetical expiration day. Below is an example of oil and gas names that appeared on this dashboard.

Looking back to last year, the data in the chart above tells us what expectations we would have if we bought a straddle on these tickers. For CVX, the straddle that expired in 30 days had an average return of 14.6%. The straddle had a 43% chance of being positive, which is relatively high considering that a straddle is in the dark, it must move enough in one direction to cover the premium of a call option and of a put option. The last column tells us that of all the positive straddles, 84% of them were positive due to the call option. In other words, CVX has been quite bullish over the past year.

This tells us that CVX has tended to make big moves relative to their option prices, and generally higher. Overlaps have worked for the past year and can be profitable both ways. So, as oil stocks such as CVX enter a historically bearish period, their 12-month performance indicates that they could make good straddle plays. This is because even if you get weakness from these stocks, which you always have, you can still profit from it. But if some of those oil stocks continue to rise like last year, you can still profit.

Conversely, if a trader thinks these stocks will be as weak as they have been in the past over the next few months, they can buy put options for a higher return than the straddle, knowing that the options have been undervalued over the past year.

Subscribers to Chart of the week received this comment on Sunday July 10th.