Another Best Way to Trade Oil
Oil prices have been rallying on news that OPEC will maintain cuts to production levels through the end of next year. The most recent agreement includes a commitment from Russia, a large producer outside the OPEC community.
OPEC nations and Russia all share a dependence on oil revenue. These countries largely rely on oil to generate income that funds government spending. Low prices have hurt these countries and they see lower production as a strategy to boost revenue in the long run.
Companies in the energy sector have been rallying on the news that prices are likely to at least hold steady for a time. Stable to higher prices should allow companies in the sector to deliver solid earnings. However, some companies in the sector may have become overbought.
An overbought condition exists when a stock has moved up in a way that traders often describe as “too far, too fast.” The concern is that stocks rarely move straight up. Since prices reflect fundamentals and fundamentals change slowly, slower price gains are better than rapid gains.
An Overbought Stock in the Energy Sector
When a stock moves too quickly, traders expect a pull back. The chart below shows U.S. Silica Holdings, Inc. (NYSE: SLCA). The stock gained more than 10% on the combination of a good earnings report and the OPEC agreement. In the past few days, the stock has been declining.
U.S. Silica Holdings, Inc. produces and sells commercial silica in the United States. This may not seem like an energy company, but the fate of U.S. Silica has largely been tied to the price of oil and gas over the past few years.
The company operates through two segments, Oil & Gas Proppants and Industrial & Specialty Products. It offers whole grain commercial silica products to be used as fracturing sand in connection with oil and natural gas recovery.
The company also makes and sells resin coated proppants, as well as sells its whole grain silica products in various size distributions, grain shapes, and chemical purity levels for manufacturing glass products, plastics, rubber, polishes, cleansers, paints, glazes, textile fiberglass, and precision castings.
Specialized products include fine ground silica for use in premium paints, specialty coatings, sealants, silicone rubber, and epoxies. These include aplite, a mineral used to produce container glass and insulation fiberglass; and adsorbent made from a mixture of silica and magnesium for preparative and analytical chromatography applications.
But, U.S. Silica’s major revenue source is the oil and gas recovery markets. Fracking relies on proppants such as sand or silica products. While silica is more expensive, it can lead to higher production rates that help companies boost profits from wells.
The Trend Is Unlikely to Be Up
The long term stock chart using weekly data is shown below. SLCA enjoyed large gains during the fracking boom. But, the stock price turned down along with the price of the commodity.
A measure of momentum known as the stochastics indicator is shown at the bottom of the chart. This indicator is designed to spot potential turning points in the stock price. Technical analysts often use momentum indicators because they find, through their experience, that momentum leads price.
For SLCA, turns in the indicator did lead significant trend reversals in price. The top and bottom in prices came after the stochastics indicator signaled a reversal in prices was due. That makes the recent signal important to consider.
In the recent price action, the stochastics indicator failed to break above 80. It is now pointing down, a bearish indication for the stock price. The stock also faces resistance near $35, an area expected to see selling pressure enter the market and hold the stock price down.
The chart action tells us that SLCA is unlikely to move higher, at least in the short run.
That down trend, or at the least a consolidation of price, for SLCA is likely to endure until there is a significant change in the company’s news. This indicates traders who want to trade the trend in SLCA should consider trades that benefit from moves to the down side.
To benefit from weakness, an investor could buy put options. But, as the chart shows, SLCA has been in a downtrend over the past few days and that has resulted in increased volatility. The higher volatility increased options premiums even more. This is normal behavior when a sell off occurs.
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 Credit spread option 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 SLCA
For SLCA, we have a number of options available. Short term options allow us to trade frequently and potentially expand 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 December 15 $32 call for about $0.80 and buy a December 15 $34 call for about $0.20. This trade generates a credit of $0.60, 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 $60. The credit received when the trade is opened, $60 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $140. The risk is found by subtracting the difference in the strike prices ($200 or $2.00 time 100 since each contract covers 100 shares) and then subtracting the premium received ($60).
This trade offers a return of about 42% for a holding period that is just a little more than a week. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if SLCA is below $32 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 $140 for this trade in SLCA.
These are the type of strategies that are explained and used in Trading Tips Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.