Out With the Old War, In With the New-USO,IYT

Out With the Old War, In With the New-USO,IYT

If it looked like happy days were here again after the Korean Peninsula appeared to be cooling, just take a look at the South China Sea and the Middle East.

 

In the former, tensions between Mainland China and Taiwan are flaring again, with the communists declaring in both word and deed that it’s only a matter of time before ‘reunification’ takes place.  War games and exercises on both sides dominated the news this week and last, as everyone positions himself for a show of strength and urges his opponent to take him seriously.

 

From there, hop over to the other side of the Eurasian land mass, where Israel has announced what many already knew to be the case – that Iran is doggedly working on its nuclear arms program in locations hidden from IAEA inspectors.  The Israelis claim to have a trove of evidence to prove the case, and it appears the major western powers are about to send inspectors into Iran with the Israeli documents to check if, indeed, a violation of the Vienna Accords took place.

 

If that’s the case, you can almost assuredly expect the U.S. to drop their support of the deal, recommit to a grave regime of sanctions on Iran, and for the rest of Europe to grudgingly follow along.

 

And that, dear friends, opens a Pandora’s box.

 

 

 

For many reasons (that we won’t delve into at the moment), proof of Iran’s failure to honor the agreement would likely isolate that country internationally and offer the opportunity to bring strong leverage on both Russia and Iran – and her many proxies in the region, from Lebanon to Syria to Yemen.

 

Several Arab nations have already cut ties with Iran of late, with Morocco being the latest – just this week – to do so.  The Moroccan government has accused Iran of  sending arms to support rebel jihadi groups in that country.

 

 

It goes without saying that the Middle East is already highly combustible, and any false move could set the region ablaze.  It’s also less clear how Iran or one or more of her proxies would react to a renewed regime of economic sanctions.

 

What is perfectly clear, however, is that oil prices would benefit greatly from such a development, both because the Iranian supply would be removed (in large part) from the open market, and because other disruptions across the region would certainly ensue in the event of a shooting war.

 

Top-out For Crude – USO , IYT

 

And yet, we have speculated here for several weeks regarding the likelihood of a temporary top for crude oil.

 

Why?

 

Our belief centers on the action of the dollar – of late, markedly higher – a phenomenon that puts great downward pressure on the commodities as a whole.

 

We would also note that rising crude prices are forcing investors, consumers and even central banks to consider the inflationary impact of such a development.  Higher yields on treasuries – even anticipation of higher rates – are one of the principal means the Fed has of battling inflation.  And because those rising rates are also responsible for the latest bounce in the buck, a circular, self-feeding process is forming that puts further upward pressure on the currency and ever more encumbrances on the price of oil.

 

 

In short, there are multiple pressures now coming to bear on the commodities, and most notably on oil.  And while we can’t say for certain in which direction the battle will ultimately be resolved, we are nearing a break point that may be felt across multiple asset classes.

 

What is certain, however, is that any sharp action in the crude pits will play a decisive role in the movement of transport stocks.

 

And that’s where we intend to play our cards today.

 

Look here –

 

 

There is no industry or sector so buffeted by the price of oil.  Revenues may be maintained in the event of a price spike, but margins will be pressured dramatically.  And that means equity prices will suffer.

 

To the trade! USO , IYT

 

Our thinking regarding oil and the transport sector is by no means original, and a look back at the relative price action between the two investment sectors reveals that the pairing is not always tradable.

 

The best results generally come when crude is on the birthing table and a strong move is expected to ensue.

 

And that’s precisely where we stand today.

 

Take a look at a chart –

 

 

This is the last year’s daily trade between NYMEX Crude, as represented by the United States Oil Fund ETF (NYSE:USO), and the Dow Jones Transportation Index (NYSE:DJTA).

 

As you can see, oil has risen some 60% over the period, while the transports have gained roughly 12%.

 

But a closer look at the action between the two shows that the transport margins have been squeezed extensively over the last three months, in line with both heightened tensions in the Middle East and the dollar’s continuing weakness (which appears now to be ending).

 

The blue arrow highlights the period in question, during which the trannies have moved in a very tight range, called a consolidation, ‘rectangle’, or congestion period by technicians.

 

What’s key here is that a rectangle can break in either direction, confirming that the sector is now awaiting its cue from the oil market.

 

 

While we could play this with either CALLs or PUTs, our preference is to use the former, as it hedges against any other influential factor that might force the transports lower.

 

We’re using the iShares Transportation Average ETF (NYSE:IYT) to represent the transports, as it’s the largest ETF available for the sector.

 

Options Trader Elite recommends you consider buying the USO October 19th 14 CALL for $0.87 and selling the IYT September 21st 210 CALL for $0.90.  Total on the trade is $0.03.

 

Pay attention to those expiries!

 

You gain from any outperformance of oil over wheels – whether USO rises faster or falls slower than IYT.

 

Note, too, that the USOs are nearly at-the-money, while the IYTs are 13.5% ($25) out-of-the-money!

 

Many happy returns,

 

Matt McAbby.

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