The trade from HELL

kaBOOM! Is about the only way I can describe the sharp reversal in oil we have seen in the past week. As many of you may know from our chat room or following me on Twitter or StockTwits, I have been accumulating USO as a reversal play in oil for quite some time. As described by Yahoo Finance:

Fund Summary – USO

The investment seeks to reflect the performance, less expenses, of the spot price of West Texas Intermediate (WTI) light, sweet crude oil. The fund will invest in futures contracts for WTI light, sweet crude oil, other types of crude oil, heating oil, gasoline, natural gas and other petroleum based-fuels that are traded on exchanges.

My preference in trading these past several years has been heavily biased toward reversals, mostly to the long side. I don’t think that it is practical or even appropriate to make a living calling bottoms and tops in the markets, but I think with a sound strategy and solid risk management, you can buy yourself enough time to catch a decent win here and there. This was one of those scenarios.

Oil started its record sell off last fall. News from OPEC refusing to trim production quantities combined with lower demand around the globe threw oil into a free fall for a few months. USO moved from about $40 to $16 with the slide seen in crude. The harder and faster it fell, the more I wanted to be in for the reversal.
USO Blog Pic

We all know oil won’t be going to $0 in our lifetime. If anything, as we use up more and more of this limited natural resource, and as our population continues to grow long term, it will squeeze the price higher, assuming we don’t ween ourselves off of it any time soon. Supply and demand..simple right?

That was my line of thinking when I bought my first 500 shares of USO at $21.50 when the slide in oil appeared to slow. I was fully prepared to average down on this trade, but hoping to scale up as we recovered. Well, oil kept selling off, harder and faster. As planned, I continued to accumulate every point to point and half drop in USO, slowly averaging down my price. After if became clear we were going to be selling off for the foreseeable future, I turned to my options background to help me manage this trade. Rather than continuing to use up equity buying up USO as it dropped, I chose to modify my strategy. Every week, I was watching oil drop hard, and pop up for a day. Rinse and repeat.
When trying to lower an average in a position, there are multiple ways to go about it. If the position has solid options liquidity, using options is a no brainer, cheap and safe way to do just that. The plan then became playing the intraday moves. For every day that crude futures spiked, USO moved up and I would sell out of the money calls into that volatility spike. I sold calls equal to the number of shares I held at the time. I didn’t think that I was at risk of getting called out and having my contracts exercised, but was happy to if that were the case since I would be locking in profit either way. As it turned out, every contract I sold expired worthless, so, I got to keep the premiums I collected from the sale. That was the first step in lowering my net average price for my long position. Seeing USO continue to drop violently day over day gave me another idea. Why not buy at the money puts when I am selling my calls into the price spikes? I collected a jacked up premium writing covered calls, and got a discounted premium when simultaneously buying puts to protect my downside. This allowed me to make money as the trade moved against me. This technique is known as hedging. I was able to do this four times over the two and a half months I held USO. This effectively allowed me to lower my average to about $18.76 on 3000 shares without ever having to purchase a single share below $19. A pretty handy technique to have in your back pocket.
Fast forward to January 29, 2015. I snatched up another 1000 shares of USO on the dip down to $16.30 as it was far more attractive to own shares at that price than waiting for a spike in price to sell my covered calls into. This dropped my average to about $18.39 for my 4000 shares. I began telling myself, that I would not keep buying shares as I was concerned about keeping balance in my portfolio. It is important to keep diversification throughout your portfolio to avoid having too many eggs in one basket. Common sense. Well, lucky for me we caught a break. News hit January 30th, that U.S. rotary rig production had fallen to a five year low. This was good news for those who subscribe to the economic principle of supply and demand. Common sense suggested that if oil producers in the U.S. were cutting back on production to stem their losses, the supply would be dropping, and prices would begin to rise in oil. This was big news because it was the first inkling we have had that something was really being done to divert the falling knife that was oil. OPEC has refused to take its foot off the gas of production, so, U.S. producers had to step in to protect their own margins. Once verifying the accuracy of the news, USO immediately began to spike. I broke my own rule in the haste of the excitement and bought another 1000 shares at $17.75 as prices climbed on big volume, for a new average of 5000 shares at $18.12.
The next few days were glorious and euphoric. FINALLY, I had received the vindication I was so aggressively seeking. Oil bounced right through the crucial $50 mental level, and USO followed right along hitting highs of $20.29 on February 3rd, on MASSIVE volume. This was the moment I waited 2 months for. I began unloading immediately into the spikes. Selling 1500 USO at $19.50 and another 1000 at $19.95. Once USO easily broke through $20, I put another order out at $20.50 hoping for a home run. That never happened, BUT I was up nearly $10k on the trade that I had been holding at or near a loss on for months. At the close of the market on February 3rd, I was faced with a difficult question, unload the remainder of my position, or hold through the crude inventory report the very next morning. Well, being the greedy home run hitter I always thought I was, I held my last 2500 shares of USO. I had a hard stop placed at $18.44.
Come the next morning, inventories were released and the numbers were not great. BUT, USO held up just fine for the most part. It wasn’t until the late day sell off in crude futures did we see USO creep toward my profit stop. Sure enough, before the day was over, my stop was taken out and I locked in the last $800 in profit for a grand total of $5400. I was okay with it. I was out of the trade and had enough lunch money to last me for a few years. Naturally, after the sell off, crude quickly rallied over $50 again and USO shot back up to the mid $19s as I write this. I will tell you why I am okay with what happened.

After the hassle and trade management that went into USO for months, the endless reading of oil nonsense, options analysis, and math, I was burned out on the trade. I feared what we witnessed in the sharp spike up could have merely been a dead cat bounce. So, while I left a ton of money on the table, I still made money on the trade and am happy with how I manged my risk over the two month period.

Where oil or USO go from here, I do not know. I may be a buyer again over the highs if we continue to recover, or a buyer and accumulator under the lows if the trend wins out. The important thing to note here is that while we do not know what direction things will go for us, having the knowledge and ability to stay flexible in a trade and to make money on it in any direction is key to our long term success. Nobody is going to call tops or bottoms perfectly all the time, and probably not even most of the time, but knowing how to stay in the trade in any direction is crucial to our survival as traders and investors.