Oil, Again, Could Be a Winning Trade
When looking for potential investments, many individual investors look for value or for specific chart patterns or indicator signals. These are all potentially profitable strategies. They must be applied with discipline and over the long run.
There are other strategies that can prove to be profitable over the long run when applied with discipline. They depend not on value or specific technical signals. Instead, there are strategies that simply depend on volatility.
Right now, as it so often is, oil is one of the most volatile financial markets. Many individual investors avoid commodities but stocks in the sector can provide exposure to the market and the volatility. This can be especially true when a company announces news.
The news brings the stock to the attention of traders. The news also forces investors and analysts to incorporate the development into their pricing models. This can lead to buying or selling and in a volatile sector, the news can lead to short term trading opportunities with relatively high potential returns.
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Company News Creates the Trade Setup
A recent Bloomberg article noted,
Teck Resources Ltd. (NYSE: TECK) Canada’s largest diversified miner, warned that fourth-quarter earnings will be “significantly” below consensus estimates following “disappointing” results at its energy unit and trail operations, as well as on inventory valuations.
Earnings will be reduced by 30 Canadian cents (23 cents) per share and earnings before interest, taxes, depreciation and amortization by C$195 million, it said in a statement.
The company expects to report a loss of C$92 million before depreciation and amortization and inventory write downs in its energy business unit, resulting in an after-tax loss of C$86 million.
Teck said that “dramatic” widening of heavy oil differentials hurt results, while a decline in commodity prices in the quarter led to pretax inventory write-downs of C$80 million.
The company expects to report an after-tax loss of C$31 million in its trail operations, citing factors including a maintenance shutdown and a fire in a silver refinery. In the third quarter, the miner reported results that trailed estimates amid rising costs in its coal business.
This news sent the stock price lower.
This breakout could be the beginning of a longer down trend after resistance held.
However, there is a short term trade that could benefit from a small, short term move.
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.
Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.
When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.
A Bear Call Spread in TECK
For TECK, we could sell a February 15 $23 call for about $1.05 and buy a February 15 $25 call for about $0.27. This trade generates a credit of $0.78, 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 $60. The credit received when the trade is opened, $78 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $122. The risk can be found by subtracting the difference in the strike prices ($200 or $2.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($78).
This trade offers a potential return of about 63% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if TECK is below $23 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 $122 for this trade in TECK.