CTMPR

Since the advent of the Oil ETF it seems that oil has taken on a larger role than simply an energy based commodity. Over the past 5+ years that these ETFs have been trading we have seen Oil prices go from the $40s to over $140 down to $30 back up to $115 and now back down to around $80. That is a tremendous amount of volatility and cannot be attributed to simple changes in supply or demand. Oil has become the ultimate inflation hedge for many investors, until the past year it was actually preferred to even Gold or Silver which are traditional inflation hedges.

Why Invest In Oil?

The Top 2 reasons are to Make Money and also to to protect yourself from rising prices (Hedge). The downside of a large flow of investment capital into oil is that there are far reaching consequences when oil gets driven beyond it’s reasonable price. It makes the cost of transportation more expensive driving up the cost of almost all goods, especially food. In order to protect yourself from rising prices you may want to invest in oil or even a Gas ETF – UGA. UGA rises and falls with the price of gasoline which is the one that affects us the most on a daily basis.

What Is The Best Way To Invest In Oil?

For the average investor who wants to hold their investments for a prolonged period of time I have found it best to go with an Oil Stock ETF instead of the futures based Oil ETFs. Over longer periods of time these ETFs almost always outperform the oil futures ETFs like USO or OIL. Here is a chart showing the performance of USO (black bars) compared to XLE (brown line) since April 2006 when USO started trading. It’s easy to see that you would’ve done much better in the oil stocks than in the USO oil futures based etf.

For short term traders there are Leveraged ETF versions that also concentrate on the oil stocks. The first one is a Double Oil ETF (2x Leverage) that basically will go up or down twice as much as XLE on a given day. You don’t want to get in these unless you know what you are doing, they are designed for short term trading and not for holding long periods. This one is offered by ProShares and has been trading since January 2007 under the ticker symbol DIG. There is also a double short version that has the ticker symbol DUG.

Direxion offers a 3X Leveraged Oil ETF (Symbol ERX) for those of you who really want some leverage. This one is based on the Russell 1000 Energy Index and it really is volatile. Again, these ETFs are only for short term investing or trading and are designed for experienced investors. They also offer a 3X Short ETF that trades under the ticker symbol ERY.

If this is your first foray into Oil Investing I would definitely recommend starting with either XLE or XOP. Once you gain some knowledge you may decide you want to venture out into the other more volatile areas of the market. Another area that’s worth looking at is the Bakken Oil Stocks which are a collection of companies that are producing oil in the Bakken Oil Field located in Western ND and Eastern Montana. There is also a Bakken oriented mutual fund that specialized in this area (symbol ICPAX). This area is one of the fastest growing production areas in the world right now, so it’s worth a look!

The whole stock market changed last Thursday when the S&P 500 plunged through the 20 month moving average in the closing hour of trading. I had used the summer lows as stops on my positions so I basically got stopped out of almost everything that day. It made me sick to think that I might be getting stopped out at the bottom but now I’m relieved I followed my “Rules”. That’s the thing about stops, they force you to use discipline instead of running on emotion.

Since we are going into the 4th year of a presidential cycle I’m still bullish on stocks, but as long as we are trading below the 20 month simple moving average I can’t be long stocks. The number for the S&P 500 ETF (SPY) is 119.33, so basically if we close the month of August below that number it’s a major warning sign for the market. Look what has happened in the past when we couldn’t get back above it ( Jan 2001 and July 2008) both failures preceded devastating 50% declines.

If we get back above 1200 on a closing basis it could lead to a huge short covering rally, so it’s the only number you need to watch.

Nibbling On Volatility

This morning I couldn’t help buying a couple things however. Gold is up another $50+ to new all time highs and the gold mining shares are mostly down, so I bought the gold mining ETF thinking it’s probably about the safest stocks around. Additionally I purchased the Inverse Volatility ETF (XIV) as the VIX spiked to 40 in early trading. Unless we are going into an all out 1987 or 2008 style crash volatility could easily peak in this area. XIV is designed to rally when volatility decreases and in my opinion is one of the surest bets when things get crazy. I never liked shorting volatility using futures because you can get hurt extremely bad in the short run (VIX spiked over 90 in 2008) but using an ETF you have a predefined risk. Even if the stock market loses 90% of it’s value volatility will eventually come back down to below 20 once it’s done trashing around. Additionally, volatility normally comes down long before stocks begin rising.

You can see it better looking at a 12 month chart from 8/4/2008 through 8/4/2009. Notice that the VIX peaked (near 90) in October 2008 but the S&P 500 didn’t bottom out until the beginning of March 2009. By the time the S&P 500 actually bottomed out the VIX had already fallen by nearly 50%.

This means that you can actually make money twice on a huge stock market decline. You can short volatility when panic is at it’s peak and then you can take some profits and use them to buy cheap stock when the averages finally grind out a bottom.

I have been holding about 1/3 cash in my SEP IRA waiting for the S&P 500 to sink back to the 20 month simple moving average. This is something it does most summers and usually represents the perfect buying opportunity. Today however is a scary day to be buying stocks because it feels like the “Sky Is Falling” and my best stocks are getting crushed. The S&P 500 is down 37 points, the Nasdaq is down over 60…. crude oil is down over $2…. even gold and silver have plunged after their earlier gains. It seems the investment world has finally lost it’s appetite for risky assets. The gains I had seen in my portfolio over the past few weeks have almost been wiped out with the majority being lost in the last 3 hours. This is why it’s so hard to be a contrarian investor. I am forcing myself to buy stock, but I would really rather be 100% in cash for the moment. I just added to my position in the leveraged oil ETF (ERX) and bought 100 shares of XIV which is the inverse volatility ETF that performs like a champ as the market recovers. The next move I am contemplating on is to purchase the Leveraged Biotech ETF that I bailed on $20 higher from here just 8 days ago. BIB however, really does feel like trying to catch a falling knife so I think I will start with a rather small position.

In reality I really don’t feel like buying anything today. When you lose thousands of dollars of profit in the blink of an eye it tends to make you gun shy, but this is where the big money is made. The large investors have been waiting for a chance to buy near the 20 month moving average. Sensing panic this morning they fueled the decline which is leading to a classic capitulation day. Today is most likely the low in most of these stocks but the odds are good that there will be another test of these lows prior to the fall rally. That’s why I will deploy part of my capital today and wait to deploy the rest either on a successful retest of the lows or when the charts actually turn up. After all, I want to be a contrarian investor, not a wild west gun slinger! By deploying your capital in a planned manner you tend to make much wiser decisions than if you fly by the seat of your pants.

Good Luck To Us All!