The energy sector has been beaten down since September and is stuck in a downtrend. However, markets don’t usually go up or down in a straight line. When markets go into oversold or overbought conditions, it is common to see counter-trend rallies. In the chart below, I am using the SPDR Energy ETF (XLE) , which is an ETF that tracks the performance of companies in the energy sector like Chevron, Exxon Mobil, Pioneer Natural Resources and Valero. To evaluate the trading action in XLE, I am using 2 technical indicators in the chart below: RSI (Relative Strength Index): You will notice that RSI almost touched the oversold region on Nov. 9 and is started to bounce back up. This is an indication that the stock has lost downward momentum and could be changing its current trend. DMI (Directional Movement Index): DMI is composed of 3 lines, DI+ (green line), DI- (red line) and ADX (blue line). When the DI- (red line) is above the DI+ (green line), it indicates a downtrend which is what XLE is experiencing at the moment. However, when the DI lines start changing direction, it indicates a possible change in the current trend. Note that both DI- and DI+ are changing direction which provides further confirmation that XLE is turning around. The Trade Set-up: A bull call spread Now that I have a directional bias in place, all I need to do is find a trade structure which will allow me to bet on an upward move in the energy sector. The trade structure I am going to use here is called a “bull call spread” also known as a “call debit spread.” XLE is a highly liquid ETF and if you look at its option chain, you will notice that it offers $1 wide strikes. This is great, because a trader can construct a $1 wide put spread and risk as little as $50 to make $50 per winning trade. To increase risk, simply add more contracts. For example, doing a 100-contract trade would risk $5,000 to make $5,000. All I need is for XLE to go up by $1 by expiration date for this trade to double my money. Here is the exact trade setup: Buy $83 call Dec 8 expiry Sell $84 call Dec 8 expiry Limit Price: 50 cents Profit target: If XLE is trading at $84 or above on expiration date, this trade will generate a 100% return on investment on the amount risked. Managing losses: An important part of any profitable trading system is that it needs to have positive expectancy. That means the winners need to add up to more than the losers. For me to create positive expectancy with this trading strategy, I will close this trade if I lose 50% of my investment (i.e. 25 cents). By doing this, every winner will cancel out two losing trades. DISCLOSURES: (None) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
