The strategy of selling a put to purchase calls, not only provides you with the opportunity to leverage your position in Chesapeake Energy Corporation (CHK), but it also provides you with the chance to get into the stock at a much lower price. After dropping to a new 52-week low in May, the stock has been trending upwards nicely, and it appears the worst news could already be priced in.
Chesapeake Energy is on track with its 25/25 plan. The goal of this plan is to increase the company's natural gas and oil production by 25%, while at the same time reducing its long-term debt by 25%. Management raised its forecast for proceeds from asset sales to the $11.5 -$14 billion ranges from prior estimates of $10-$12 billion. According to Zack's (see table below), earning per share estimates for 2013 are projected to increase significantly to $1.70, from of $0.46 for 2012.
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The chart clearly indicates that EPS is projected to trend upwards over the next few years. Generally, when the price of the stock moves above the EPS line, the stock tends to trend higher and vice versa. If the current trend is maintained, it should be able to trade above this line in the near future.
The stock generated several positive divergence signals when it dropped down to $13.32, a new 52-week low in the month of May. The $19.50-$20.50 ranges present a zone of strong resistance. These are former points of support now turned into resistance. It has challenged this zone several times since June of this year, and so far, each attempt to break out has failed, clearly demonstrating the level of resistance this zone has to offer.
On the positive side, the Bollinger bands are tightening up and when this occurs, it usually results in a strong break out. The last time this took place from ct 2010-Jan 2011, the stock trended in a tight range for roughly 4 months before breaking out. The same pattern appears to be in play right now. The bands are tightening, and the stock has been trading in a rather tight range for the past 3 months.
The stock will probably dip down to the $17.50-$18.00 ranges 1-2 times more, and then it should be ready to challenge the 19.50-20.50 ranges again. A weekly close above 20.50 should result in a test of the 25.00-27.00 ranges.
Suggested strategy for Chesapeake Energy Corporation
This play has two parts to it. The first part entails selling a put, and in the second part, calls are purchased with the proceeds from part 1.
The April 2013, 18.00 puts are trading in the $2.28-$2.32 ranges. If the stock pulls back to the $17.50-$18.00 ranges, these puts should trade in the $3.00-$3.30 ranges. We will assume that if the stock pulls back to the stated ranges, the puts can be sold for $3.00 or higher. The proceeds from the sales of the puts will be used to complete the second part of the trade.
The April 2013, 25 calls are trading in the $1.05-$1.08 ranges. If the stock pulls back to the stated ranges, these calls should trade in the $0.70-$0.80 ranges. We will take the midpoint and assume that these calls can be purchased for $0.75 cents or better. For each put sold, you will have the option of purchasing up to 4 calls. If you want to leverage your position in even further, you could purchase calls that are further out of the money.
Benefits and risks associated with putting this strategy to use
It provides you with the opportunity to significantly leverage your position in this stock for a relatively low cost. You only need to put up 1,800 for each put, but you can control up to 400 shares in the process. If you purchased 400 shares today, the cost would be roughly $8,000.
If the stock trades below the strike price, you sold the puts at, the shares could be assigned to your account. Depending on the number of calls you purchased, your cost per share could range from $15.75 (if you purchased one call only) to $18.00 (if you purchased four calls). Assignment usually occurs on the last trading day of the option
The only real risk is that you have a change of heart and you now feel that the stock could trade well below the strike price you sold the puts at. In this case, you could roll the put. Buy back the old puts and sell new out of the money puts.
Only put this strategy to play if you are bullish on the stock and consider closing half the position out if the calls are showing gains in the 60%-100% ranges.
EPS chart and Zack's consensus estimates data, obtained from zacks.com. Some of the historical/research data used in this article was obtained from zacks.com. Options tables sourced from yahoofinance.com.
Disclaimer: It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies - let the buyer beware.