The Beaten Down Oil Sector Could Provide a 142% Gain
Trade summary: A bull call spread in TOTAL S.A. (NYSE: TOT) using the May 15 $30 call option which can be bought for about $2.06 and the May 15 $32.50 call could be sold for about $1.33. This trade would cost $0.73 to open, or $73 since each contract covers 100 shares of stock.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $73. The maximum gain is $177 per contract. That is a potential gain of about 142% based on the amount risked in the trade.
Now, let’s look at the details.
Oil prices have plummeted after coronavirus dampened demand and Saudi Arabia failed to reach a deal with Russia to restrict output. The downtrend could persist as momentum continues to fall.
But some companies may be nearing a bottom. For example, TOT has found reason for optimism. Management recently noted, according to Business Wire that the company’s CEO told employees that they have seen bad markets before.
He noted that in the current market, the company could reduce spending on capital projects by $3 billion. This would be 20% less spending than the company’s $15 billion budget for capital expenditures last year.
Management can also find $800 million of savings in operating costs. This is $300 million more than the company was already targeting for this year.
These two goals are most likely within reach as is a third step to savings the company announced which is a suspension of the stock buyback program. TOT was planning to buy $2 billion of its shares in 2020 and will no suspend that, using the cash for operations.
These steps will help the company prosper with oil prices “on the order of $30 per barrel” according to Barron’s. That is optimistic with oil trading below that level but a bounce in the market is possible and that bounce could help TOT.
The shares have been moving down, consistent with the trends in oil and stock markets.
The stock is now at levels it traded in 1993. TOT is, of course, much larger and more profitable than it was almost thirty years ago. The current price is most likely an overreaction to the bad news.
However, there are significant risks in both oil and stocks which make TOT vulnerable to further selling and additional declines. Strategies designed to manage risks will be better for conservative investors.
A Specific Trade for TOT
For TOT, the May 15 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 May 15 $30 call option can be bought for about $2.06 and the May 15 $32.50 call could be sold for about $1.33. This trade would cost $0.73 to open, or $73 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 $73.
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 TOT the maximum gain is $1.77 ($32.50- $30= $250; $2.50 – $0.73 = $1.77). This represents $177 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $73 to open this trade.
That is a potential gain of about 142% 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 TOT 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.
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.