CNBC: The Only Way Is Down for Oil
The business network, CNBC, is featuring bears in the oil markets. The network recently reported:
“Oil prices are likely to fall even further over the coming weeks, analysts told CNBC [recently], as a sharp sell-off in global equities combines with intensifying fears about a market that could soon to be awash with crude.”
The latest wave of energy market selling comes amid reports of swelling inventories and forecasts of record U.S. and Russian output. Heightened worries of a possible economic slowdown in 2019 have also added downward pressure to the value of a barrel of oil.
“The only way is down,” Tamas Varga, senior analyst at PVM Oil Associates, said in a research note published Tuesday.
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“There are lots of variables regarding next year’s oil balance but based on available data, information and sentiment, it is fair to say that any price rally will be met by fierce resistance from the sellers’ side,” Varga said.
Both Brent crude and U. S. West Texas Intermediate (WTI) oil benchmarks have crashed more than 30 percent since reaching a peak in early October, largely because of swelling global inventories.
“For a brief period, the energy market in 2018 bore all the hallmarks of having stabilized with some sense of normalcy returning but all that changed in October,” analysts at UBS said in a research note published Monday.
“Uncertainty and volatility reign once again,” they added.
Uncertainty is especially high after a closely-watched meeting of major producers earlier this month failed to soothe growing market concerns about oversupply in 2019.
The deal reached by OPEC and non-OPEC members in a bid to boost the market is yet to have its desired effect. The energy alliance agreed to take 1.2 million barrels per day (bpd) off the market for the first six months of 2019.
The 15-member OPEC cartel said it would reduce its output by 800,000 bpd, while Russia and the allied producers will contribute a 400,000 bpd reduction.
However, the cutbacks do not go into effect until January, and Russia has warned that it will only gradually taper off output.
“Some kind of short-covering can happen any time (from) now until the end of the year but no long-term joy is on the horizon for oil bulls,” PVM Oil Associates’ Varga said.
Trading the Fall
In a Bloomberg article, Harold Hamm, founder of oil-and-gas giant Continental Resources Inc. (NYSE: CLR), is fighting regulations that could adversely impact the industry.
“Hamm’s biggest concern is environmental policy. “Climate change isn’t our biggest problem—it’s Islamic terrorism!” he told the Republican National Convention in 2016.
“Every onerous regulation puts American lives at risk.” He forged a relationship with Trump, who installed a close ally, former state Attorney General Scott Pruitt, for a brief, headline-grabbing stint as U.S. Environmental Protection Agency director.
Hamm, Continental and its political action committee plowed more than $3.1 million into the past two elections, almost entirely for Republicans and Trump-focused PACs. But, his campaign hasn’t been able to stop the decline in the company’s stock.
The short term picture highlights a potential trading opportunity in the stock.
After briefly basing, the stock appears to be in the early stages of its next significant trend and the direction appears to be down. Risks are high so it could be best to consider a strategy that limits risks.
A Trading Strategy To Benefit From Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
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 traders can consider is the bear call spread. This is a trade that 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. The call is sold to limit the risk of the trade. So this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It 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 and is also known.
A Bear Call Spread in CLR
For CLR, we could sell a February $42.50 call for about $2.70 and buy a February $45 call for about $1.80. This trade generates a credit of $0.90, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $90. The credit received when the trade is opened, $90 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $160. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($90).
This trade offers a potential return of about 43% of the amount risked for a holding period that is relatively short. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if CLR is below $42.50 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 $160 for this trade in CLR.
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.