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Relative Strength in the Market’s Sea of Weakness

Relative Strength in the Market’s Sea of Weakness

Trade summary: A bull call spread in Continental Resources, Inc. (NYSE: CLR) using the March 20 $19 call option which can be bought for about $1.80 and the March 20 $21 call could be sold for about $0.90. This trade would cost $0.90 to open, or $90 since each contract covers 100 shares of stock.

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  • In this trade, the maximum loss would be equal to the amount spent to open the trade, or $90. The maximum gain is $110 per contract.  That is a potential gain of about 22% based on the amount risked in the trade.

    Now, let’s look at the details.

    This trade is based on an earnings report and the stock’s rally on the news. According to ZACKS.

    “CLR reported fourth-quarter 2019 adjusted earnings of 55 cents per share, which beat the Zacks Consensus Estimate of 52 cents. Moreover, the bottom line rose from the year-ago earnings of 54 cents per share.

    Revenues of $1,195.1 million beat the Zacks Consensus Estimate of $1,131 million. Also, the figure increased from $1,149.3 million in the year-ago quarter.

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  • The strong quarterly results can be attributed to rising year-over-year oil and gas production, and higher realized crude price.”

    There was more good news in the report.

    “As of Dec 31, 2019, Continental’s estimated proved reserves were 1,619 MMBoe, reflecting 6% year-over-year growth. The reserve replacement ratio was 178% in 2019.

    Production from continuing operations averaged 365,341 barrels of oil equivalent per day (BOE/D) in the quarter, higher than 324,001 BOE/D in the year-ago period. This was supported by output growth at the company’s South and Bakken assets.

    Oil production in the quarter came in at 206,249 barrels per day (Bbls/d), up from 186,934 Bbls/d a year ago. Natural gas production jumped from 822,402 thousand cubic feet per day (Mcf/d) in fourth-quarter 2018 to 954,556 Mcf/d.”

    But there was some less favorable news.

    “Crude oil equivalent price in the quarter fell to $33.49 per barrel from $37.13 in the prior-year period. Natural gas was sold at $1.73 per Mcf, down from $3.26 in the year-ago quarter. However, average realized price for oil was $51.33 a barrel, up from $50.06 in the prior-year quarter.

    Total operating expenses of $901.3 million in the fourth quarter rose from $818.9 million in the December quarter of 2018.

    Total production cost rose to $111.2 million from $104.3 million in the year-ago quarter. Exploration costs in the quarter were $7.3 million compared with $3.3 million in the year-ago period. Transportation costs rose to $61.1 million from the year-ago level of $49 million.

    In 2020, the company expects to generate free cash flow within $350-$400 million, assuming WTI crude price at $55 per barrel and Henry Hub gas price at $2.50 per Mcf. The metric implies significant fall from the 2019 level of $608.4 million.”

    The stock did rally on the news, and the pattern is more bullish than the charts of many other stocks with CLR rallying into the down gap, a potential buy signal.

    CLR daily chart

    The weekly chart shows a pattern that is visible in almost every chart with a quick price drop.

    CLR weekly chart

    What makes CLR bullish is the fact the stock moved into the gap seen on the daily chart and met the downside price target on the weekly chart, clearing the decks for a possible rally.

    A Specific Trade for CLR

     For CLR, the March 20 options allow a trader to gain exposure to the stock. This trade will be open for about six weeks and allows for traders to turn over capital quickly, potentially compounding gains several times a year.

    A March 20 $19 call option can be bought for about $1.80 and the March 20 $21 call could be sold for about $0.90. This trade would cost $0.90 to open, or $90 since each contract covers 100 shares of stock.

    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 $90.

    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 CLR the maximum gain is $1.10 ($21- $19= $2; $2 – $0.90 = $1.10). This represents $110 per contract since each contract covers 100 shares.

    Most brokers will require minimum trading capital equal to the risk on the trade, or $90 to open this trade.

    That is a potential gain of about 22% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.

    A Trade for Short Term Bulls

    As with the ownership of any stock, buying CLR could require a significant amount of capital and exposes the investor to standard risks of owning a stock.

    To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.

    Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.

    To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.

    This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.

    bull call spread

    Source: The Options Industry Council

    Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.

    This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.

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