How To Capture Big Gains On The Next Spike In Oil With Limited Downside Risk

Jul.20.12 | About: Occidental Petroleum (OXY)

By Timour Chayipov and Mark Bern, CPA CFA

We will apply a strategy that allows an investor to achieve one of three outcomes:

  1. Achieve an outsized gain from a spike up in oil prices
  2. Achieve a very small gain if oil prices go nowhere
  3. Own stock in a great company at a price that is 20 percent below the current price

The potential gains range as high as nearly 60 percent with virtually no losses, unless our targeted stock drops in price by more than 20 percent. Our example is based upon Occidental Petroleum (NYSE:OXY), a well-managed integrated oil company with a 10-year track record of raising dividends. But instead of buying the stock, we will elect to tie up less money, thereby increasing our potential return on invested capital. We will create an artificial buy/write position and pay for it by selling a deep out-of-the-money put option. The artificial buy/write position consists of a bull call spread, which is really much easier to understand than you might think. For a detailed explanation of this strategy, please refer to our earlier article on silver using Silver Wheaton (NYSE:SLW).

A bull call spread consists of two option contracts: one long call option and one short call option, both with identical expirations, but with the long call option having a lower strike price. You will catch on quickly as I walk you through the example.

We need a few bits of information to help put the strategy into proper perspective: today OXY is trading at about $86.65 per share, as of this writing. The 52-week low is $66.36 and the 52-week high is $108.23. We would love to own OXY near its low. That is important, because we recommend that investors only use this strategy on stocks that he/she really would like to own long term. You will understand why in a moment.

To begin, we sell one OXY January 2014 put option with a strike price of $70 per share and collect the premium of $7.95 per share ($795 for each contract; each contract represents 100 shares). I would really like to own shares of OXY at $70 per share, so I am very comfortable with this strike price. The earlier article linked above explains more about how options work if you need more detail. We will skip the detailed explanations for the sake of brevity at this point.

Now we have collected $795 and we will use that to purchase the bull call spread which will consist of:

Buying one OXY January 2014 call option with a strike price of $90 for a premium of $11.30 per share ($1,130)

Selling one OXY January 2014 call option with a strike price of $110 for a premium of $4.25 per share ($425)

The net cost of the bull call spread ($11.30 - $4.25) is $7.05 ($705). That amount is covered by the premium we already collected by selling the put for $795, and leaves us with a net cash gain of $90 for making the trade.

If the stock price of OXY goes up, both of our call option premiums will increase and the put option premium will decrease. But the call premiums may not increase as much as the underlying stock does until the option goes in-the-money (in this case, the $90 strike price call that we bought will be in the money when the price of OXY stock hit $90.01). The reason the premium increases will lag the increases in the underlying stock price is because of the time value of the option. But as time passes, the time value will decay (decrease) and the closer we get to the expiration date, the less a factor will be the time value. On the expiration date, there is no time value at all and the option premiums are priced solely based upon the relationship of the strike price to price of the underlying stock. In other words, if the OXY stock price is $100 at expiration, the premiums on the three options will be:

  1. Long January 2014 $90 call option will have a premium of $10.00 ($100 - $90)
  2. Short January 2014 $110 call option will expire worthless since the strike price is greater than the stock price.
  3. Short January 2014 $70 put option will expire worthless since the strike price is less than the stock price.

There are really four possible outcomes for this trade strategy (six if you consider extreme cases of boom or crash). I listed only three above because those are the obvious ones, and the ones most questions tend to be centered around. The fourth is simply that, as in the example just above, the price of the stock ends up between the two strike prices of our options. As you can see, calculating the outcomes is accomplished with simple math. The option that is in-the-money has a value equal to the stock price at expiration, less the strike price and the other two option contract expire worthless. Assuming the same outcome as above -- that the stock price is $100 -- our result would be:

  1. Gain on the long call $1,000
  2. Gain on the Premiums paid/collected $90
  3. Total gain on trade $1,090
  4. Return in a margin account (50% margin) 31.1%
  5. APR in a margin account (50% margin) 20.8%
  6. Return in a tax-deferred account 15.6%
  7. APR in a tax-deferred account 10.4%

The next possible outcome is if the price of OXY is at or above the $110 strike price of our short call option. I am going to show this one a little differently so you see all the detail. The results would be as follows:

  1. Value of the spread at expiration $2,000
  2. Less: cost of the bull call spread premiums -$705
  3. Premium collected on expired put premium $795
  4. Total gain on trade $2,090
  5. Return in margin account (50%) 59.7%
  6. APR in margin account (50%) 39.8%
  7. Return in tax-deferred account 29.9%
  8. APR in tax-deferred account 19.9%

The next possible outcome occurs when the price of OXY remains below the $90 strike price of our long call, but above the $70 strike price of our short put position. All option contracts will expire worthless. Here is how that breaks down:

  1. Premiums paid for bull call spread -$705
  2. Premiums collected for selling put $795
  3. Total gain on trade $ 90

The returns are inconsequential, but the main point here is that you didn't lose money. And now the final possible outcome occurs when the price of OXY falls below the $70 strike price of the put. You just pay the $7,000 you've been holding in your account to secure the put, and hold onto the stock until it goes back up. This puts your cost of the stock much closer to its low than its high, which is where we prefer to enter long-term investments anyway.

My personal sentiment on OXY is that eventually demand for oil will continue to increase, and we are going to see the price rise above that $110 level. Oil doesn't need to hit $140 per barrel for that to happen. Remember, production is increasing every year. My 5-year target price for OXY is $125. If I end up buying the stock at $70 and collecting a dividend that increases every year, I am a happy camper.

The results for owning the stock outright are very similar, except in the instance where the stock price drops by 20 percent or more. If you bought the stock at the current price of $86.65, and it dropped by 20 percent, you would have a loss equal to 20 percent less the dividends collected. In this scenario, you would have lost only the difference between the strike price ($70) and the $69.32. This is the beauty of the strategy. We limit the downside risk compared to an outright purchase of the stock.

Disclosure: I am long OXY.