Energy Is Rallying. How to Play It With Options.

ADVISOR TAKE – Key takeaways from the Barron’s Advisor editorial team

• Energy prices are rising as demand outpaces supply.
• Commodities analysts have fretted about scarcity for months, and developments this past week have brought those concerns to the forefront.
• Options in the Energy Select SPDR ETF offer immediate exposure to this theme.

The energy market may soon deliver a hard lesson to a world that has grown accustomed to having what it wants whenever it wants it, and almost instantaneously.

Demand seems to be exceeding supply, and that is creating imbalances in the oil and natural-gas markets. China’s energy system is teetering on the edge of crisis. In the United Kingdom, some gas stations have run out of fuel due to labor issues. Commodities analysts have fretted about scarcity for months, and developments this past week have brought those concerns to the front of the market’s narrative.

Oil prices are surging. They are at multiyear highs. On Tuesday, when stock prices tumbled, and bond yields spiked, the energy sector demonstrated extraordinary strength. The Energy Select SPDR exchange-traded fund (ticker: XLE) rose 0.32%, which seems tiny until you compare it with the S&P 500 index’s more than 2% decline.

Many of the ETF’s components surged sharply higher— Schlumberger (SLB), for instance, rose more than 2%. The sector’s bravado performance when the stock market was the weakest it has been in some time hasn’t gone unnoticed. Many investors will likely try to pick winners on the belief that a best-of-breed stock will outperform the entire sector.

The thinking is generally sound, but energy investing is a nuanced, often volatile and cyclical pursuit. It is arguably better to borrow a trick from the institutional trader’s playbook—buy an ETF, or options on an ETF, to get broad exposure to an investment theme.

An ETF trade offers immediate exposure to an investible theme. It provides investors time to do the necessary research to pick top stocks, or they simply own the ETF and ride whatever currents emerge.

The Energy Select SPDR ETF’s top 10 holdings include Exxon Mobil (XOM), Chevron (CVX), EOG Resources (EOG), ConocoPhillips (COP), Schlumberger, Marathon Petroleum (MPC), Pioneer Natural Resources (PXD), Kinder Morgan (KMI), Williams Cos.(WMB), and Phillips 66 (PSX). The stocks are a who’s who of the energy sector and provide broad exposure to rising energy prices.

The ETF is trading toward the top of the past year’s trading range, which is one reason why aggressive, risk-minded investors might want to consider using an options strategy in lieu of buying the fund. Options cost less money than the underlying equity, which means less money is at risk should something suddenly change the energy market’s dynamics.

With the ETF at $52.89, you could buy the December $55 call option for about $2.31. If XLE is at or above $57.31 at expiration—the strike price plus the premium—the trade is profitable. At $60, for instance, the call is worth $5. During the past 52 weeks, the ETF has ranged from $26.98 to $56.65. It is up 40% this year, compared with a 16% gain for the S&P 500.

The trade’s profitability is predicated on the ETF reaching a higher trading range, which could become a reality if the gloomy outlooks about oil prices and supply prove true.

Investors who would buy XLE at a lower price might consider a “risk reversal” trade—selling a downside put option and buying an upside call. The strategy, a favorite of this column, often enables investors to profit from rallies for free in return for agreeing to buy a security at a lower price.

Where this will end is anyone’s guess. Options offer a way to rent exposure to the theme through the next three months, providing investors precious time to evaluate a market twist that is old news to some, and a threat and opportunity to others.

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Originally Posted on September 30, 2021 – Energy Is Rallying. How to Play It With Options.

Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.