Over the years I have learned two things about seasonal trends in the financial markets:

1) They’re great

2) Especially when they work

In a nutshell, a well established seasonal trend – i.e., a tendency of a given index, market, commodity or stock to decline (or fall) on a consistent basis during a repetitive time frame – can be extremely useful in telling you what a given market “should” be doing.  The catch of course is that a seasonal trend does not tell you what a market “will” be doing the next time around.  So a little common sense comes in handy (and if there is one thing that people have said consistently about me it’s that I have little common sense, er, I mean “a” little common sense).

A Bullish Seasonal Trend in Energy Stocks 

Figure 1 displays the annual seasonal trend for Fidelity Select Energy fund (ticker FSENX), over the past 25 or so years. 

Figure 1 – Annual Seasonal Trend for Fidelity Select Energy (ticker FSENX); 1988-2011

Does anything jump out at you?  Essentially by looking at this chart for about three tenths of a nanosecond you immediately become something of an expert on energy stocks.  This is so because by now you have almost certainly come to learn that energy stocks have demonstrated a strong tendency to advance from roughly late January/early February into early to mid June. 

Now does this mean that energy stocks enjoy a straight line advance during this time frame year in and year out?  And more importantly, does this mean that energy stocks are certain to be higher come June than they are right now?  Sadly, the answer to both of these questions is “no.”  Still, if you had to bet on energy stocks right now would you bet on the bull or the bear? 

Figure 2 displays the growth of $1,000 invested in FSENX only during February, March, April and May every year starting in 1989. 

Figure 2 – Growth of $1,000 invested in FSENX February through May (1989-2011)

The results in Figure 2 display exactly what I wrote about a moment ago - a strong tendency to advance, but no guarantee from year to year and no reason to expect a straight line advance in any case.  So if you choose to buy and hold FSENX for four months you now have some idea of what to expect. 

Finding a Low Dollar Risk Trade

There is nothing wrong with buying and holding FSENX (or the ETF ticker symbol XLE or Profunds Energy fund ticker RYEIX).  But let’s take a look at an alternative that requires a small investment and for most, a lower dollar risk.  It should come as no surprise that this stock has a very high correlation (82%) to XLE (the exchange traded energy fund) as you can see in Figure 3.

Figure 3 – COP is Highly Correlated to Broader Energy Index Fund (XLE)

In Figure 4 you can see that COP is coming off of an oversold condition.

Figure 4 – COP bouncing off of oversold

The position I want to consider is a bullish out-of-the-money (OTM) butterfly spread on ConocoPhillips (ticker COP).  The position I have chosen to examine involves:

-Buying 2 May COP 70 calls

-Selling 3 May COP 80 calls

-Buying 2 May COP 90 calls

Figures 5 and 6 display the particulars for this position

Figure 5 – COP OTM Butterfly

Figure 6 – Risk Curves for COP OTM Butterfly  

A few things to note:

-The total investment to enter this position is $516.

-$516 represents the maximum risk.

-If the stock simply bounces backup to the most recent high near $75, this position stands to register a gain of 80 to +100% (as you can see in Figure 3, such a move easily possible (within one standard deviation).

-If this position does manage to register a reasonable gain, there are many potential ways to adjust this position to lock in a profit and let some part of the position ride (however, this topic is beyond the scope of this article).

Summary

So several questions arise.  Will energy stocks in general experience an advance in the months ahead?  More importantly in this case, will COP advance in price?  The cold, hard reality in this case is that if COP fails to advance at some point between now and mid-May this position will certainly lose money as time decay begins to eat away at the option prices.  Still, this position has several things working in its favor.

The bullish seasonal trend for energy stocks bodes well for the potential of witnessing at least a halfway decent interim gain.  And remember, it doesn’t take that much of an up move for this position to register a large percentage gain.

All this being said – and with one more reminder that no position – including this one – comes with a guarantee, a small dollar risk position with a favorable headwind and the potential for a large percentage return is exactly the kind of position that traders should be looking for, particularly in today’s volatile markets. 

Jay Kaeppel
Staff Writer and Author of “Seasonal Stock Market Trends”

Optionetics.com ~ Your Options Education Site

NOTES:

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