Oil Remains Volatile and Trading Opportunities Abound
Oil has historically been a volatile market. In part, that is due to the fact that it a leveraged market. But it is also due to the fact that so many factors affect the price. This was highlighted in a recent article from ZACKS which noted,
“The newest numbers, which showed that daily crude output remained above one million barrels for the 21st month, further confirms the status of North Dakota (centered on the Bakken formation) as one of the hottest shale plays in the United States.
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There is increasing evidence that a fundamental change is occurring in the oil market. WTI crude, the American benchmark, popped above $76 a barrel and was trading at multiyear highs in early October. A looming shortage of the commodity on Iran sanctions helped in driving oil prices higher.
Now, in a reversal, oil is facing a two-pronged attack: rising supply from major producers and fear that an economic slowdown will dampen the outlook for demand. Oil’s troubles helped send the index into a tailspin, leading to a 40% drop from recent highs.
With weaker oil prices denting producer profits, oil volume in North Dakota is expected to experience muted growth. Winter weather and road restrictions in the coming months will also put brakes on the region’s breakneck activity.
Apart from the robustness in oil prices, there is another factor that helped to speed up Bakken output growth – the 1,170-mile-long Dakota Access Pipeline.
Energy Transfer L.P.’s ET mega project has a capacity to carry about 520,000 barrels of oil per day (or more than 50% of North Dakota’s output). The conduit has successfully bridged the gap between Bakken players and producers in other U.S. oil-producing areas like the Williston and Permian basins.
The geographically constrained Bakken Shale’s crude has now better access to Gulf and East Coast refineries and also reaches international markets.
The pipeline, where energy majors like Phillips 66 PSX, Enbridge Inc. and Marathon Petroleum have invested, has helped to improve the region’s drilling economics by lowering transportation costs for operators.
Moreover, the pipeline’s service has bolstered the revival of Bakken output, with large operators like Oasis Petroleum Inc. (NYSE: OAS) counting on the Dakota Access Pipeline to send a major portion of their products to market.
But with the pipeline’s spare capacity vanishing rapidly amid high demand, there is a need for infrastructure that can allow for the movement of more oil.
A potential expansion of the Dakota Access Pipeline and the proposed Liberty Pipeline, which will provide opportunity to shippers to secure transportation service from the Bakken production areas to Corpus Christi, TX, are touted as solutions.
While the Dakota Access expansion is likely to augment the pipeline’s capacity by 50,000 barrels per day, the Liberty pipeline will have an initial throughput capacity of 350,000 barrels per day and is expected to start operations in another two years.”
This could constrain shares of OAS which shows a possible consolidation and reversal in a down trend.
Despite the steep drop, additional weakness is possible.
A Trading Strategy To Benefit From Potential Weakness
The prospects of a further short-term gains in OAS seem to be remote. But significant weakness is also unlikely. Traders should consider using an options strategy known as a bear put spread to benefit from the expected trading range in the stock.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics For OAS
The bearish outlook for OAS, at least for the purposes of this trade, is a short-term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the May 17 $9 put can be bought for about $2.80 and the May 17 $6 put can be sold for about $0.70. This trade will cost about $2.10 to enter, or $210 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $210. This loss would be experienced if OAS is above $9 when the options expire. In that case, both options would expire worthless.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in OAS, the maximum gain is $0.90 ($9 – $6 = $3; $3 – $2.10 = $0.90). This represents $90 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $210 to open this trade.
That is a potential gain of about 43% of the amount risked in the trade. This trade delivers the maximum gain if OAS closes below $6 on May 17 when the options expire.
Put 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 $210 for this trade in OAS.