XOP - XOP: Lessons Learned From Recent Call Debit-Spread Loss

Summary

• We used the call debit spread strategy last month to get long this fund.
• Shares rallied somewhat after our buy-call before turning over last month.
• By monitoring the fund's trend, implied volatility, and theta numbers, we believe we can be quick in taking losses over time.

Intro

We wrote about SPDR S&P Oil & Gas Exploration & Production ETF ( XOP ) last month when we stated that we were buying into the fund's up-move. The reasons for our bullishness at the time were self-explanatory. We had a continuation pattern on the technical chart, plus also a MACD buy signal on strong momentum . The MACD signal in particular was convincing, as this indicator is a solid read on both the momentum and the trend of the underlying. Furthermore, the fact that the signal took place well below the 'Zero' line demonstrated that the fund was ready to rally out of oversold conditions. XOP, in fact, managed to do just that by rallying above $145 a share by the 27th of January. At that stage (with the fund making new highs on a daily basis), you can bet that plenty of longs got trapped on the wrong side of the trade. One week later to the day, XOP now finds itself approximately $10 or 7% down from that January 27th high ($135+ per share). We exited our bullish position (regular February Call Debit Spread strategy ($140/$142)) for a loss as the spread was moving further out of the money and time was obviously not on our side.

Before we get into why exiting the bullish position was the best decision (even if XOP turns around and rallies from here), it is important to point out the following. Taking losses is a very important component of the trading and investing industry. In fact, many professional traders prefer to call themselves risk managers because they inevitably book more losses than gains in their careers. This mindset revolves around the premise that one should let their profits run while cutting losses short when directionally trading.

Weakening Trend

As we can see below, the first buy signal was given by means of the MACD crossover, and then we used the ADX by signal to confirm the new bullish trend. However, in the aftermath of the second signal, the ADX trend-following indicator continued to decline, as we see below. This means that XOP's bullish trend was beginning to fade, and our bullish stance was now under question. Remember, when trading directionally, a clear trend is an absolute requisite in order to book profits on a consistent basis. Therefore, the weakening trend which basically took place all throughout January was the first sign for traders to begin liquidating long positions.

Depressed Implied Volatility

Below is an implied volatility chart of XOP where we see that implied volatility has remained depressed over the past month, despite the gradual uptick we have seen in recent sessions. Why is this noteworthy? Well, as we mentioned in our last piece on XOP, buying call options or call spreads is advisable when implied volatility is trading close to 52-week lows. In fact, XOP's IV rank currently comes in at 11, which means the fund's implied volatility is ultra-low compared to its 52-week average (options prices are trading much cheaper than normal). Therefore, previously purchased calls and call spreads would not have been able to take advantage of rising vega, which is another tailwind for a bullish call position.

No Intrinsic Value

Since our call debit spread went out of the money, this means the spread lost all its intrinsic value and only had extrinsic or time value at this point. Being so close to expiration (February 17th) brought risk to this position due to the fact that theta decay always picks up steam aggressively in the final weeks before option expiration. A rule to go by is that we always want to have little extrinsic value in our spreads when they are in the money but yet plenty of extrinsic value (time left to expiration) when they are out of the money. Many directional traders make the mistake of leaving options expire worthless in the hope of their positions somehow miraculously turning around. Be proactive. Protect your capital. Be ruthless in booking losses.

Conclusion

Last month, we bought the $140/$142 call debit spread on the expectation of rising prices in XOP. Shares actually rallied to almost $146 a share by the 27th of last month before finally turning over and losing ground. By keeping on top of the ETF's trend, its implied volatility as well as its theta numbers, we must ensure losses are always cut very quickly when our initial assumption is wrong. We look forward to continued coverage.

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