“It's their rink, their ice and their town. But tonight we got our fans with us!”
--Reggie Dunlop, Slap Shot

Wayne Gretzky once said don’t skate to where the puck is, skate to where the puck is going. The same can be said of any successful trading strategy.

Everywhere you turn, people are talking about the eye-popping run in crude. Texas tea is up 380% since the end of 2003, 157% since the beginning of last year and 50% since February. That’s what was and it’s clearly what is. The path to profitability resides in our ability to discern what will be.

For purposes of context, I was a commodity bull since 2003, offering that energy and metals would share the leadership baton until energy overtook the financials as the top weighted sector in the S&P.

I pulled back those horns into the end of last year, a premature evacuation ripe with opportunity cost. The thought process was predicated on the notion that we arrived at the crossroads of our wishbone world with hyperinflation on one side and watershed deflation on the other.

The government decided to dance with the devil we know (inflation) rather than the devil we don’t (deflation). It affected this dynamic by socializing risk and injecting more than one trillion dollars into the marketplace. The ramifications of these policies will profoundly affect our future but by design, the government pushed out the collective comeuppance.

As a trader, I’m not as concerned with the ultimate destination as much as the path that we take to get there. I’ve generally avoided the energy space this year and focused my attention on the financials and select tech, taking what the market gave me while preserving capital and keeping my powder dry.

Towards the end of last week, I began building short-side exposure in the energy realm. Catching cusps is a dangerous proposition, whether it’s grasping at a falling knife or getting in the way of parabolic frolic. It’s a generally accepted trading axiom that money is made between the twenties and we should avoid the red zone whenever possible.

With that said and respected, I share these thoughts with two caveats. First, I’m typically early, which is as damaging as being wrong if you’re not there to cash in your chips. Second, while a seismic structural shift could occur at any time, my motivation is to simply capture a trade.

The bull case for energy is loud and proud as a function of the price action. There are supply constraints, emerging market needs, incremental demand from China (following the earthquake), pressure on the U.S dollar (the price of socialization), unreliable alternative sources, psychology (furthered by a recent Goldman Sachs (GS) report) and perhaps the biggest risk in my view, the potential for geopolitical tension in Iran.

On the other side of that ride, we have political agendas into the election, incessant (unconfirmed) chatter that margins on crude futures will be raised, faltering demand by an already strapped U.S consumer and the unfortunate truth that all roads will ultimately lead to debt destruction through deflation. See the chart below.


Click to enlarge

The rationalization of risk versus proactive positioning is a fine line that every trader must walk. I don’t profess to be smarter than the market and the Trading Gods often remind me that if I don’t stay humble, the tape will do it for me. I’m simply trying to capture the disconnect between perception and reality and manage risk as I find my way.

I’ve attempted to do that in a few ways, including using options to shape my exposure. With volatility at levels last seen in October, I’ve initiated put positions in select drillers, such as Halliburton (HAL), and the US Oil Fund (USO). As a tertiary play, I bought some calls on Continental Air (CAL) with a tight stop-loss below $16.

Volatility is the opposite of liquidity and as such, I understand the Federal infusion of capital has weighed on the level of implied volatility. Still, as our mission is to attempt to use price to our advantage, I’m making this bet through options with hopes of winning two ways (directionally and volatility expansion).

My time horizon is a few months and I plan to rotate risk and “trade around” core exposure as a function of price. I’m also eyeing the metals as an upside hedge should I anticipate further commodity appreciation. Again, the single biggest caveat to the short energy thesis, in my view, is an uptick in Middle East acrimony.

As the market is a prescient beast, that unfortunate thought would certainly explain the incessant bid we’ve seen to date.

Be that as it may, my expectation is that the dollar (and volatility levels) will lift as equities and energy slip in sync. I say this with a conscious nod that The Bernanke Swap has replaced The Greenspan Put as the backbone of perceived security.

Nobody is bigger than the market. That’s a lesson I may soon learn but it’s one that our esteemed Fed Chairman likely will as well.

Good luck.

R.P.


 

In the Emerald City on May 27th? Join us at 4 P.M. at Revolution Bar & Grill (at the Experience Music Project) to mingle with your fellow Minyans!


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