A Unique FANG Trade
Source: Diamond Back Energy.com
Analysts and traders are closely following the FANG stocks. This group has captured attention and delivered gains as an indicator of the new economy. Some analysts modified the acronym to FAANG but the stocks included in the list are usually the same.
Facebook, Apple, Amazon, Netflix and Alphabet (parent company of Google) are the stocks to watch in this market, especially as the companies implement new privacy regulations in Europe. But, there is another FANG stock that traders should be aware of.
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The Oil Sector Has Its Own FANG
Oil prices are in the news and, here again, we find that FANG can be a sector bellwether.
Bloomberg reports that, “Russia breached its oil-output quota agreed with OPEC for a third straight month as the producing alliance prepares for crucial talks this month on increasing supplies.
Oil output averaged 10.97 million barrels a day in May, almost unchanged from a month earlier, according to data emailed Saturday by the Energy Ministry’s CDU-TEK statistics unit. That means its compliance with the production quota of 10.95 million was close to 95%, same as in April. In March, the rate was 93%.
Russia and Saudi Arabia last month signaled they may start increasing supplies in the second half of this year in response to a surge in prices. The move is yet to be approved by other members of the Organization of Petroleum Exporting Countries and its allies, and some such as Ecuador have said they aren’t in favor. The 24-member group is scheduled to meet in Vienna later this month to discuss the future of their landmark 2016 accord.
Several Russian companies want the production cap eased as the grand alliance has already achieved a key goal of draining a surplus in global stockpiles. The deal with OPEC has been a success and “we believe that the global energy market is currently balanced,” President Vladimir Putin said May 25. “Our arrangements were never intended to remain in force forever,” he said.
Russia currently has about 500,000 barrels a day of spare production capacity, according to Gazprom Neft PJSC, the country’s third-largest producer. The company and Rosneft PJSC will lead the ramp up once output restrictions are eased, according to Citigroup Inc. and ESAI Energy LLC. Rosneft this week started testing its capacity to increase output.
OPEC’s de-facto leader Saudi Arabia is also lifting supply. Production rose to the highest in seven months in May, according to tanker-tracker Petro-Logistics. Kazakhstan, the second-biggest oil producer in the former Soviet Union and a signatory in the supply deal with OPEC, is set to boost output to a record in May, data compiled by Bloomberg showed.”
Pressure on Oil Explains the Drop in Oil Stocks
Russia’s production explains part of the decline in the oil sector. The downtrend can be seen in many stocks, including Diamondback Energy, Inc. (Nasdaq: FANG). That chart is shown below and appears to show a clear topping pattern.
A Trading Strategy While Awaiting Better News
To benefit from the expected weakness in the stock, an investor could buy put options. But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility.
In this case, with a bearish outlook, a call option should be sold.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that is important to consider is the bear call spread. This trade uses two calls with the same expiration date but different exercise prices. Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received.
A Bear Call Spread in FANG
For FANG, we have a number of options available. Short term options allow us to trade frequently and potentially increase our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell a June 15 $120 call for about $1.45 and buy a June 15 $125 call for about $0.45. This trade generates a credit of $1.00, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $100. The credit received when the trade is opened, $100 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $425. The risk is found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($100).
This trade offers a potential return of about 23% of the amount risked for a holding period that is about two weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if FANG is below $120 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $425 for this trade in FANG.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.