A Chance To Make Up To 75% On Halliburton With Little Downside Risk

| About: Halliburton Company (HAL)

By Timour Chayipov

Halliburton (NYSE:HAL) is one of the biggest oil service companies in the world, operating in about 80 countries. The stock closed Friday, June 30, 2012 at $28.39.

I believe that the company is undervalued by at least 60% relative to its peers or using the discounted cash flow model (DCF). The reason for this discrepancy: it is still battling with BP in the court over responsibilities for the Gulf of Mexico disaster.

My personal opinion is that BP doesn't have much chance to prevail legally because in the oil industry (where I work) generally contracts between oil companies and service companies assign responsibilities in the same way: the service company must maintain a reasonable profit margin (not including any risk premium to its own price) but the oil company retains all responsibilities for any kinds of disasters. Unless BP can prove that the disaster is solely due to work performed by Halliburton without BP supervision, approval or involvement, it is highly likely that BP will retain the majority, if not all of the remaining responsibility. HAL has reserved $300 million to cover any adverse decision and it is unlikely, in my opinion based upon my personal observations from within the industry, that any outcome would exceed that amount.

But if I am wrong (always a possibility) there is still some potential that HAL will be penalized. So if that happens the price of its shares may drop even more, but I would be very comfortable owning HAL shares at $23 if the price were to drop that low.

So my recommendation to play this situation is to use an artificial buy/write strategy. The reason that this is called an "artificial" strategy is because we do not actually own the stock; instead, we use options to build a long position in the stock using less money. In this strategy we will not actually own the stock unless it falls below my target of $23 per share. If that happens, we will simply hold onto this quality stock until it recovers, which it ultimately will do, collect the dividends and maybe sell some calls when the price and premiums allow us to do so without risking a loss.

Our first step is to sell January 2014 put option(s) with a strike price of $23.00 and collect a premium of $3.00 per share. We then use that premium to construct a Bull Call spread(s): January 2014 strikes $30/$40 for $3.07. What this means is that we buy a January 2014 call option with a strike price of $30 with a premium of $4.50 per share (or $450) and we sell a January 2014 call option with a strike price of $40 and a premium of $1.43 for a net cost of $3.07. Thus, this trade has a total cash outlay of $0.07 per share plus commissions. Commissions should be less than $10 per trade (2 trades = <$20) and if you use options extensively in managing your portfolio, as I do, you can get the cost down to as little as $1 per trade, which is inconsequential to the outcome.

We will also need to maintain a cash or cash equivalents balance in our account (brokers differ on their definitions of cash equivalents, so it is best that you contact your own broker to get a better understanding of what you can use here) to secure the put option. If you are using a taxable, margin account you will need to have somewhere between 30 percent and 50 percent (depending upon your broker) of the amount that would be required to purchase the shares if you are put the stock, or from $690 to $1,300 per 100 shares (or for each contract). If you are using a tax-deferred account, you will need to have the full 100 percent to secure the put(s), or $2,300 per 100 share (or for each contract) represented by the put option contract(s) sold. But remember that the benefit of the tax-deferred account is the tax-deferral (or tax avoidance if in a Roth account) and that benefit really adds up over the years.

In the following example we are using a taxable, margin account with an assumed 50 percent of the strike price required to secure the put option(s).

So now that we have put things in place, let's explore the possible outcomes:

If the HAL stock price increases to above $40 in January 2014 our call spread(s) will be in the money and trade for $10 each ($1,000 for each spread), and most of this will be profit because the price which we paid for the bull call spread ($3.07) is almost fully compensated for by the premium which we received from our short put(s) sold for $3.00 each which will expire worthless. The $0.07 difference can be fully recovered by selling a 3 month ''dividend call(s)'' against our long position.

If we look at the October 2013 call options currently available, we'll see that the $35 strike price option pays a premium of $0.23 per share. It seems reasonable to assume that the price will be unlikely to rise so far in such a short time because the litigation with BP is likely to be prolonged. So we collect the premium and have all our cash outlays covered, including commissions. If the price were to jump that quickly, our profit would be reduced but our APR would increase because of the greatly reduced holding period and we would just unwind the rest of the positions and look for a new opportunity.

If these dividend calls expire worthless in October, we can enhance our income from repeating the sale of new calls with a higher strike price, if appropriate, again for three months out (January 2013). Now we are essentially receiving the dividend (or maybe more) without owning the stock and with a much lower capital requirement (the amount required to secure the put).

If the stock price of HAL is below $30 in January 2014 but above $20 we won't lose anything because again our short put(s) will expire worthless and the premiums received will compensate for price of the call spread(s), assuming that we sell at least one dividend call(s) during the holding period.

The only way to lose money in this strategy is if HAL's stock price falls below our short put strike ($23), but at this level we should be happy to own the shares (as we are obligated to buy the stock at put strike in this case), because from that level HAL has terrific appreciation potential. However, while this is not a very likely outcome it must be accounted for because it is always possible. Therefore, it is very important to use this strategy with companies that we really would like to own with put strike prices at which we would be very comfortable buying.

So, in essence, this strategy is like holding a free lottery ticket with a high probability of wining 75 percent or more. I am sure that there will be detractors who will claim that their strategies will make higher returns over the same holding period. But many of the "better" strategies also come with much higher risk levels.

I hope that readers enjoy this article and the possibilities of the strategy as I plan to write more articles employing the same strategy as I find appropriate companies with which to employ it. This strategy has worked well of me over the years and I hope it will do as well for others.

Disclosure: I am long HAL.

Additional Disclosure: One note that is important for readers is that there are two authors writing under the contributor name of K202 now. My (Timour Chayipov or tchayipov) specialties are in the area of options strategies while the original K202 author (Mark Bern whose responses will show up as the author responses) specializes more in dividend/growth and enhanced, long-term investing. We both answer questions and comments to articles according to our knowledge and availabilities since we live halfway around the world from each other it provides nearly around-the-clock coverage. It may seem a little confusing at first, but we hope that readers will adjust to the change and that we will continue to try to provide the same level of quality in each future article that either of us writes under this contributor name.