The Bear Market in Oil Could Provide New Opportunities
Oil prices have slid below the level associated with a bear market.
Many analysts, including those at ZACKS believe the price will remain low as the market deals with supply concerns. The firm recently reported,
“Crude is reeling under the effects of supply glut along with fears of economic slowdown, which has been weakening commodity demand.
Higher than expected output from Russia and record level of production from the prolific shale plays of the United States, even amid pipeline constraints, have been raising concerns.
Markedly, the U.S. crude market has shifted from year-over-year storage deficit to a surplus. Current crude supplies, which stand at 441.5 million barrels, are up 1.1%from the year-ago figure and 7% from the five-year average.”
Zacks noted other factors weighing in the industry:
“Moreover, Fed rate hikes are likely to make borrowing costlier, impacting capital intensive sectors including energy and others, which will have to bear the rising cost of capital. This may rather slow down economic activities in general, undercutting oil demand further.
Further, the dollar strength is playing a spoilsport by making the crude dearer for investors holding foreign currency.
Notably, the lingering trade conflict with China, an impending global economic slowdown and several geopolitical crises are likely to hinder growth of the U.S. economy. As it is, the Fed slashed its 2019 estimate for U.S. GDP growth to 2.3%, lower than its September projection of 2.5%.
Weakening economic growth is likely to impact oil prices and demand. In fact, global oil demand is already showing signs of slowdown, especially in China and India. Moreover, the waivers on Iran oil sanctions are likely to continue till April, raising supply glut concerns.
Further, the oversupplied oil market is not likely to wane anytime soon amid the softening demand, which is further expected to dent investors’ sentiment.
As it is, the oil price rally in the first nine months of the year did not really filter down to the stock prices quite well. Further, with the plunge in the crude over the past few months, share prices of the energy stocks have been on the red territory.
Making things worse, Fed’s decision of hiking rates and reducing outlook for 2019 took a beating on oil prices and spooked investors further, as is evident by the share prices of a host of leading energy companies that hit new 52 week lows before the end of the year.
Oil supermajors like Exxon Mobil Corporation, Royal Dutch Shell plc and Chevron Corporation dipped to all hit new one year low levels.
Various other noted energy players like Apache Corporation, Schlumberger, QEP Resources, Antero, Baker Hughes, Marathon Oil, Marathon Petroleum, Oceaneering International, Oasis Petroleum, Suncor, Phillips 66, Nabors, Canadian Natural, Core Labs, Encana, Helmerich & Payne also touched 52 week lows.
Hence, an immediate crude price rise may not be round the corner.” This sets up a trading opportunity in Schlumberger (NYSE: SLB).
The long term trend is decidedly down.
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 SLB
For SLB, we could sell a January 18 $36 call for about $1.50 and buy a January 18 $38 call for about $0.70. This trade generates a credit of $0.80, 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 $80. The credit received when the trade is opened, $80 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $120. 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 ($80).
This trade offers a potential return of about 66% 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 SLB is below $36 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 $120 for this trade in SLB.
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.