The Perfect Hedge: How to Beat Crude Oil Volatility

What has been moving the market lately? Crude oil prices and that is pretty much it. Crude oil has been very volatile of late (+/- 3% swings) and I have been asking myself: Knowing that crude oil moves the market, how do I take advantage of this?

Try a hedge…sounds complicated, but it’s not. Here, we won’t short any stocks; rather, we will be long two stocks. One that you expect to go up when oil goes up and one you expect to go up when oil goes down.

Typically, when oil goes up, all the agriculture and materials/minerals names move up as well. Retailers and other stocks dependent on consumer spending are the laggards. The reverse is true when oil sells off.

Here are the hedges to try:

Buy Apple (AAPL) or Research in Motion (RIMM) and Mosaic (MOS) or Potash (POT). All these stocks are high growth, high momentum for the more aggressive investor.

If you don’t like the agriculture stocks, substitute them for a natural gas/oil stock such as Anadarko (APC), Apache (APA), or Petrobras (PRB). I'd definitely use put protection if you select a natural gas/oil stock (see below for explanation).

If you are a more conservative investor, then try buying Monsanto (MON) or Deere (DE) - probably Monsanto given that Deere is in the dog house after sub-par guidance last quarter - and CostCo (COST) or Wal-Mart (WMT). Monsanto and Deere are both agriculture-related plays and usually trade with oil, but they are much less volatile. CostCo and Wal-Mart are direct consumer spending plays and both stocks are best-of-breed.

As long as oil remains volatile (not necessarily going higher) you should be able to limit your losses when the market sells off and maximize your profits when oil rallies. For someone who might like to try an aggressive strategy, consider buying a put option on the U.S. Oil Fund ETF (USO) which mimics the price of crude oil. The put option will increase in value when crude oil declines and decrease in value when crude oil rallies.

Right now, the path of least resistance for crude oil (in the near term) is lower so the put option might be a good idea. However, my long term view of oil remains intact (bullish) and this pull-back is merely a correction, a very much needed one.