This Oil Stock Could Deliver Big Gains
Trade summary: A bull call spread in Concho Resources Inc. (NYSE: CXO) using the August $55 call option which can be bought for about $2.80 and the August $60 call could be sold for about $1.05. This trade would cost $1.75 to open, or $175 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 $175. The maximum gain is $325 per contract. That is a potential gain of about 85% based on the amount risked in the trade.
Now, let’s look at the details.
Oil stocks were recently highlighted in a Barron’s article which noted,
“Oil prices and stocks were spiking on Tuesday after a European stimulus deal helped boost global markets. Brent crude futures rose above $44 for the first time since March 6, just before a production war between Saudi Arabia and Russia sent prices lower.
One analyst says it’s time to buy oil producers because they’ll benefit from steadily rising prices. Simmons Energy’s Mark Lear upgraded his rating to Overweight on Devon Energy (DVN), Diamondback Energy (FANG), and Parsley Energy (PE).
He has also been recommending CXO, which he considers his top pick among oil producers.”
The stock has been forming a base for some time, setting up a potentially bullish break out.
Barron’s noted, “The rally in oil prices hasn’t yet been matched by the stocks themselves, Lear notes, but that could change.
“The positive sentiment after EU reached a stimulus deal pushed equity markets higher and spilled over to oil markets,” wrote Hans van Cleef, senior energy economist at ABN AMRO Bank.
Lear notes that oil stocks have lagged behind the commodity in recent weeks, with the XOP ETF falling 28% from its recent peak even as WTI futures rose 2% over the same period.
“We’re not out of the woods from a recovery standpoint with COVID’s resurgence impacting demand, U.S. operators returning production capacity to the market in the third quarter and OPEC+ bringing some volumes back in July, but with the second quarter in the rearview mirror and E&Ps expected to generate substantial free cash flow, the second half should prove a good set-up for E&P to get back some of the recent weakness,” Lear wrote.
That should benefit all of the producers. But Lear sees particular value in a few of the companies that have been overlooked by the market in recent weeks.
CXO is down sharply from its highs and could be attractive to value investors.
A Specific Trade for CXO
For CXO, the August 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.
An August $55 call option can be bought for about $2.80 and the August $60 call could be sold for about $1.05. This trade would cost $1.75 to open, or $175 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 $175.
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 CXO, the maximum gain is $325 ($60- $55= $5; 5- $1.75 = $3.25). This represents $325 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $175 to open this trade.
That is a potential gain of about 85% 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 CXO 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.