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Exxon, Chevron: The Bigger They Come...

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Oil's two biggest names may be about to fall.

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Paired trades always seem a bit too exotic to me - they're just not my style. However, a pair trade sometimes calls out to me too clearly to be ignored, and I play it accordingly. At times, these trades deal with fundamentals (like my Patriot Trade earlier this year); other times, like today. they concern technicals.

Unless you've been living under a rock, you're well aware of the massive decline we've seen in the commodity world. This has been due in part to a global slowdown; however, much of this decline may be due to the massive liquidation and forced selling that occurred when hedge funds bid the market adieu, and money fled to safer havens. Regardless, commodity-related stocks have fallen, and fallen hard. No commodity class is immune.

To play the decline, equity traders have recently focused on new ETF favorites such as the Proshares Ultrashort Basic Material ETF (SMN), or the Ultrashort Oil and Gas ETF (DUG). These plays have provided excellent trading opportunities; however, it's now purely a guessing game as to how far these areas still have yet to fall. While trades may abound in the commodity sector as a whole, I'm particularly drawn to the energy space due to the incredible discrepancy I see developing.

Despite the pain we've seen throughout the sector, the largest major integrated oil companies -- Exxon-Mobil (XOM) and Chevron (CVX) -- have held up reasonably well, all things considered. Speculators may conclude this is due to dividend yield, institutional sponsorship, or management; however, from a technical perspective, it simply looks like 2 larger ships taking longer to sink.

At the time of this writing, Exxon is trading 18.74% off the highs reached on May 22nd, while Chevron is trading 26.86% of its highs of the same date. While this may seem like a steep decline, the DJ US Oil and Gas Index is off 44.55%, with the kicker being that Exxon makes up 36.35% of the Index, while Chevron makes up 14.09%.

In summary, 2 stocks, making up over 50% of the index, have fallen an average of 22.8% (average decline of an equal amount of Exxon and Chevron), while the index has fallen almost double that amount.

While the math shows a disconnect, the technical picture shows that it's time for Exxon and Chevron to fall, and for the Oil and Gas Index to perk up. In trading terms, it might be time for the most beaten-up stocks to bounce.

My trade is simple: I'm going to go long the Pro Shares Ultra Oil and Gas Index (DIG) and short Exxon and Chevron. The DIG is a leveraged ETF, which gives me double exposure to the group. This means I won't need a 1-1 correlation; rather, I'll need to go long 2 units of DIG for every 1 unit I want to short of the combined XOM and CVX. Furthermore, because Exxon represents almost double the amount of Chevron shares, I would short double the amount of shares of Exxon as I would Chevron.

Breaking it down even further, let's assume someone wanted to commit $18,000 to the trade. They would buy $6,000 of DIG, and subsequently short $9,000 of Exxon and $3,000 of Chevron.

If you think the oil and gas areas have further to fall, then it's only a matter of time before the big boys join the party. However, if you feel the selling has been overdone, the bounce will clearly come from those most beaten-up.

Either way, the pair trade makes sense, as the liquidation has created a disconnect that shouldn't last long.
Position in XOM (and will be adding the others today)

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