Update On A Winning SeaDrill Strategy And The Chance To Lock In An Extra 5% In 4 Months

| About: Seadrill Limited (SDRL)

On the 24th of August, we wrote an article where we put out a strategy that involved selling covered calls and naked puts simultaneously. Since then, the trade has moved in our favor. The calls have lost over 60% of their value, and the puts are trading 25% lower. Today we wanted to update our views on SeaDrill (NYSE:SDRL). At that time we noted that we were not bearish on the stock and that the only reason we were putting out the trade was because the stock was trading in the overbought ranges. As we were bullish and continue to remain bullish on the long-term prospects of the stock, we also advocated the selling of puts.

Some Reasons to be bullish on Seadrill:

  • A superb yield of 8.6% which is hard to find in this low rate environment
  • It has a projected 3-5 EPS growth rate of 48%
  • Net income increased from $1.26 billion in 2009 to $1.48 billion in 2011
  • Cash flow increased from $3.95 in 2010 to $4.22 in 2011
  • Sales versus one quarter up 12.8%
  • A good interest coverage rate of 4.6
  • Sales increased from $3.2 billion in 2009 to $4.19 billion in 2011
  • Annual EPS before NRI increased from $2.60 in 2009 to $2.90 in 2011
  • EBITDA increased from $2.05 billion in 2009 to $2.3 billion in 2011
  • It has a high beta which makes it a good candidate for covered writes or you can also sell puts if you are bullish on the stock.

Charts of Interest

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The competition

SeaDrill versus Noble energy (NYSE:NE), Ensco plc (NYSE:ESV), and Transocean Ltd. (NYSE:RIG)

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Technical outlook

On the 24th of August the stock was trading above the +1 standard deviation Bollinger band (as indicated in the chart below) and when this occurs there is a tendency for the stock to pull back.

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Our exact comments at that time were as follows:

The stock is overbought and is set to run into pretty strong resistance in the 42.00-42.30 ranges. If it trades to these ranges and fails to hold, it will put in a double top formation. Double top formations in general are bearish formations. Note that the RSI and stochastics are also trading in overbought ranges. Additionally, the stock is trading above the + 1 standard deviation mark, and stocks generally have a tendency to pull back after this occurs.

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The stock traded as high as $41.72 on the 27th of August and $41.71 on the 14th of September. In doing so it put in a triple top formation (indicated in the chart below), which is generally viewed as a more bearish development than a double top formation. Since then prices have pulled back and both the call and the put options have lost value. There is a minor level of support provided in the 37.50 ranges and if it closes below this level, then it is very likely to test the $35.50 ranges. The support in the $35.00-$35.50 ranges is rather strong and a test of these ranges would make for a good long term entry point.

Let's take a look at what the options are doing right now?

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We sold the Jan 2013, $42.85 calls at $1.30 or better. On the day the strategy was put out, the calls were trading in the $1.25-$1.40 ranges. Over the next few days the calls traded well above $1.40 so it should have been relatively easy to sell the calls at $1.30 or better. The calls are currently trading in the $0.45-$0.55 ranges. If we take a price of $0.50, then the calls have lost over 60% of their value in roughly 1 month.

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We sold the Jan 2013, 35.85 puts at $1.45 or better. The puts are currently trading in the $1.05-$1.15 ranges. If take the midway point and assume a price of $1.10, then these puts have shed 24% over the same period of time.

Suggested strategy going forward

As the stock is in a corrective mode, we would hold onto the calls as there is a good chance that it could test the $35.500-$36.50 ranges before trending higher. At that point, the calls should be almost worthless, and we would consider buying them back and closing the position out.

In terms of the puts, there are two options. Hold onto the current puts with the intent of having the shares put to your account if the stock trades below the strike price. The other option would be to close the position and bank the profits with the intent of selling the same puts when the stock trades to or below $36.50. We would tend to favor this option as it provides you with the chance to get into the stock at even better price.

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We would wait for a break below $37.00 before attempting to sell puts again. Ideally, a test of 36.50 would be a good place to put this strategy into play. The stock is currently trading at $39.33, and if it tested support in the $35.00-$35.50 ranges, the same options could trade past the $2.00 ranges. The Jan 2013, 35.85 options are currently trading in the $1.05-$1.15 ranges. This is a high beta stock, and a $2.50-$3.50 drop in price will have a huge impact on the premium these puts command. For this example, we will assume that the puts could be sold for $1.80 or better. If the stock trades below the strike price, the shares could be assigned to your account, but your final price will be significantly lower compared to individuals who held onto the original option. After closing the current position out, you would have a gain of $35 per option. Your final price if the stock was put into your account would be $33.70 per share. If the stock was not put to your account, you would walk away with a gain of 6% in roughly four months when the extra $35 was factored in. If the extra $35 is not factored in, your gain translates to 5%. Individuals who did not get a chance to put this strategy into play before can still sell puts if the stock pulls back to the suggested ranges and still have the opportunity to lock in an extra 5% in roughly four months. On a yearly basis, this translates to a yield that is far higher than the stock's current annual yield.

Risks

If the stock trades below the strike price you sold the puts, the shares could be assigned to your account. This should not be a big deal as one only sells puts when one is bullish on the long-term prospects of the stock. If the shares are assigned to your account, you get the chance to get in at a much lower price. If you have a change of heart after selling the puts because you now feel that the stock could trade significantly below the strike price, then you can roll the puts. Buy back the old puts and sell new slightly out of the money puts with more time on them.

Conclusion

The calls that were sold in August have lost over 60% of their value. As the stock appears to be in a corrective phase, there is a good chance that it will be testing the $35.50-$36.50 ranges before trading past $42. If the stock pulls back to these ranges, investors should close the call position out. The puts have also lost value, and investors can hold onto them with the intent of having the shares assigned to your account. On the other hand, as the stock appears ready to trend lower, you can bank you current gains of 25% and resell these puts at a higher premium if the stock trades down to the $35.50-$36.50 ranges.

Options tables sourced from yahoofinance.com. Competitor's data sourced from yahoofinance.com. EPS consensus chart sourced from zacks.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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was prepared for Tactical Investor by one of our analysts. We have not received any compensation for expressing the recommendations in this article. We have no business relationships with any of the companies mentioned in this article.