This Sector is About to Surprise Investors With a Big Bounce

Back in 2010, as the U.S. was trying to claw its way out of the financial crisis, unemployment was at 10%, consumer confidence was below 50, and oil prices… were at about the same level they are today.

The price of West Texas Intermediate (WTI) crude oil plummeted more than 30% since June, hitting a four-year low this week at $73.25 a barrel.

This marks the fourth major correction in oil prices since the beginning of the Great Recession. And a look back shows an emerging trend that traders could leverage into 50%-plus profits in the next few months.

In the chart below, we see that no prior sell-off since 2009 has eclipsed the low of the previous year — let alone pushed prices to a multiyear low. This tells me that oil is in a very oversold condition.

Oil Prices

Further, the three previous corrections have lasted an average of about five months, which is how long the current sell-off has been going on. Even more interesting, is that prices regained an average of 64% of their drop within six months of their low.

Date of Correction
​in WTI Crude Futures
High PriceLow Price% Drop% Drop
Recovered
After 6 Months
7/08-1/09$147.27$33.20-78%35%
5/11-10/11$114.83$74.95-35%88%
3/12-6/12$110.55$77.28-30%70%
6/14-Present$107.68$73.25-32%

I doubt that oil will trade back to its highs above $107 a barrel any time soon, but I do believe that this sell-off presents a statistical anomaly that screams reversion to the mean. And we can profit from that bounce.

As we near the end of 2014, the global economic picture, while far from perfect, is in much better shape than the last time oil prices were this low.

With the drastic sell-off in crude, one might think there’s been a catastrophic drop in demand, but that’s simply not the case. The International Energy Agency (IEA) forecasts global demand will increase from 680,000 million barrels a day (bpd) in 2014 to 1.1 million bpd in 2015.

The bigger contributor to falling prices is supply. U.S. production is expected to surge to a 45-year high in 2015. At the same time, OPEC nations, which control one-third of the world’s oil supply, are feeling the pressure of reduced price control and dragging their feet on production cuts.

But the story goes something like this: When producers saw oil prices were dropping and no one was slowing production, they pumped and shipped as quickly as they could to capture market prices before they fell too far. Now they are stuck with a supply glut, lower prices and only one option: reduce production.

Oil is still a manipulated commodity. And you can bet your bottom dollar the oil companies here and abroad are not in the business of selling oil for less than it costs to get it from the ground.

There is a wide range of estimates for the cost of producing a barrel of oil, but many experts believe the cost in the United States is in the mid-$70s. And that’s just breakeven.

Saudi Arabia cut prices for crude sold to the U.S. earlier this month, in what was likely an effort to squeeze the margins of U.S. oil drillers and slow their production.

The bottom line is that cheap oil — or at least oil this cheap — is not here to stay. I am certain that production will slow to allow prices to moderate. And the oversold condition on the charts points to a bounce sooner rather than later.

Even if oil prices only recover 30% of their recent decline, which is less than in each of the past three corrections, they would trade back up to about $84 a barrel.

The United States Oil ETF (NYSE: USO) reflects the price of WTI light, sweet crude oil. If futures hit $84 a barrel, USO should trade to roughly $31.85. This is about 11% above current prices, but we can leverage that move into 50%-plus profits with a call option strategy.

USO Call Option Trade

Today, I am interested in buying USO Apr 25 Calls for a limit price of $4.50.

USO Call Option
Risk graph courtesy of tradeMONSTER.

This call option has a delta of 79, which means it will move roughly $0.79 for every dollar that USO moves, but it costs a fraction of the price of the stock.

The trade breaks even on expiration at $29.50 ($25 strike price plus $4.50 options premium), which is 2.6% above current prices.

If USO hits my $31.85 target, our call options will be worth at least $6.85 for a 52% profit. Once you enter the trade, place a good ’til cancelled (GTC) order to sell your calls at that price.

Recommended Trade Setup:

— Buy USO Apr 25 Calls at $4.50 or less
— Set stop-loss at $1.20
— Set price target at $6.85 for a potential 52% gain in five months

If you have a question or comment about today’s strategy, please send it toeditors@profitabletrading.com.

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