This Oil Stock Closed the Gap and Set Up a Possible 54% Gain
Trade summary: A bull call spread in Hess Corporation (NYSE: HES) using the June $52 call option which can be bought for about $2.18 and the June $55 call could be sold for about $1. This trade would cost $1.18 to open, or $118 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 $1.18. The maximum gain is $182 per contract. That is a potential gain of about 54% based on the amount risked in the trade.
Now, let’s look at the details.
In recent trading, HES reached an important technical level. The stock rallied back to the gap seen at the beginning of March. A gap is an area on the chart where no trading takes place. Technical analysts believe that closing a gap can be an important buy signal.
The rally coincides with an analyst upgrade on the stock. From Barron’s,
“A drop in oil demand has caused most energy companies to reduce their budgets for exploration. Hess is no different, cutting its capital expenditures to preserve cash in the pandemic.
But Hess also has access to one of the most promising oil discoveries in the world, and once production resumes the company will have a lot of high-margin barrels to sell.
That’s the main reason J.P. Morgan analyst Arun Jayaram upgraded Hess stock [recently] to Buy from Neutral. Jayaram’s new price target is $53, up from $37.
Hess and Exxon Mobil (NYSE: XOM) are drilling for oil off the coast of Guyana in South America. They say they have already discovered more than 8 billion barrels of recoverable oil.
Hess has had to spend money in advance of production, souring some investors on the stock. But Jayaram expects all that spending to pay off in the years ahead, as Hess is able to produce low-cost barrels of oil and other companies will have to scramble to find new resources.
“We suspect there will be a dearth of long-cycle projects that will move through development over the next few years given the collapse in oil prices and the state of producer balance sheets,” Jayaram wrote.
“As such, we believe HES will be well positioned in the next upcycle as the company is poised to deliver significant incremental high-margin oil barrels at a time when there will be limited competition from other long-cycle barrels and U.S. shale producers will be less incentivized to grow at the same rates in previous times.”
Hess is slowing investment in the near term as it deals with the ultralow prices caused by the pandemic and an oversupply of oil. It’s reducing capital expenditures to $1.9 billion from $3 billion this year, and Jayaram thinks it will cut even further to $1.7 billion next year.
But the analyst expects Hess to come out in much better shape than other companies.
Jayaram models a 15% oil growth compound annual growth rate between 2019 and 2025, “which compares to the flattish profile of its diversified E&P [exploration and production] peer group, and a reduction in the company’s Brent oil price break-evens to only $37 per barrel in 2025” from $50 per barrel today.”
The longer term chart shows that HES is breaking important resistance and could test recent highs on a rally.
A Specific Trade for HES
For HES, the June 19 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 June 19 $52 call option can be bought for about $2.18 and the June 19 $55 call could be sold for about $1. This trade would cost $1.18 to open, or $118 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 $118.
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 HES, the maximum gain is $1.82 ($55- $52= $3.00; $3.00- $1.18 = $1.82). This represents $182 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $118 to open this trade.
That is a potential gain of about 54% 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 HES 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 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.