Energy Sector: 2 Option Income Trades With Limited Risk And Potential Yields Over 45%

Includes: HAL, SLB, XLE
by: Parsimony Investment Research

The Energy Sector Select SPDR (NYSEARCA:XLE) is up over 30% from the recent lows in October, but the energy stocks may be running out of steam. As shown in the chart below, XLE is struggling to break through the top of its short-term range.

The sector is still in a long-term down trend (50-day moving average is still below the 200-day moving average), and we believe that this rally should now be faded.

Energy stocks have led the market higher since October riding on hope that the U.S. economy is stabilizing. However, we believe that the U.S. economy continues to face significant headwinds (e.g., high unemployment, European credit contagion, weak housing market, high debt levels, etc.) and the current "relief rally" is likely to be short-lived.

In addition, commodity prices (including oil) seem to be stalling as well, which should put further pressure on the energy sector over the short-term.

All that said, we have recently been looking for some short-term trades that will benefit from a market pullback, focusing specifically on cyclical sectors that could lead the market lower over the next few months (e.g., financials, energy and materials). Below are a few trades that we recommend in the energy sector.

Ways to Short the Sector

There are several different ways to put on a short position in a market or stock, with varying degrees of risk and reward:

  1. Inverse ETFs - Short the broader market or specific sectors.
  2. Individual Stocks - Short a basket of individual stocks or ETFs.
  3. Options - Variety of bearish option strategies for optionable stocks.

See our Primer on Short Selling for further details about the techniques that we use for short selling.

Since shorting individual stocks is a difficult endeavor (and requires disciplined risk management), we believe that the easiest and safest way to take advantage of a pullback in energy stocks is to write bear call spreads.

A bear call spread is a great strategy to employ to generate income on a stock that you believe is a good short candidate. Bear call spreads are typically created by selling a near-the-money call and buying an out-of-the-money call (a few strikes higher than your short strike). By buying the call with a higher strike, you limit your risk to the difference between your long strike and your short strike (less the premium you receive on the credit spread). If the stock stays below your short strike, both options will expire worthless and you get to keep the premium (income). Since you are selling upside volatility with this strategy, it will also perform well if the stock remains flat.

Tactical Strategy

Below are examples of bear call spreads for two large oil and gas services companies, including a chart of the stock and a graph of how the spreads perform under various pricing scenarios.

The trades highlighted below have an average return on margin of 51% and have a maturity of 46 days (March 2012 expiration). Note: The short strike should be the approximate price you would be willing to short the stock based on your analysis. The long strike should be your approximate stop loss level.

Halliburton Company (NYSE:HAL) provides various products and services to the energy industry for the exploration, development and production of oil and natural gas worldwide. It operates in two segments, Completion and Production, and Drilling and Evaluation.
HAL is still in a long-term downtrend and we believe that this trend will continue over the next few months. As shown in the call spread analysis below, the trade that we recommend will yield 47.1% on margin if the stock remains below $38.00 between now and the March 2012 expiration.

Schlumberger Limited (NYSE:SLB), together with its subsidiaries, supplies technology, integrated project management and information solutions to the oil and gas exploration and production industries worldwide.

SLB has been range bound since mid-October and has recently failed to break through the top of its range ($77.50). We believe that SLB will now test the bottom part of this range over the next several months. As shown in the call spread analysis below, the trade that we recommend will yield 55.3% on margin if the stock remains below $77.50 between now and the March 2012 expiration.

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

Additional disclosure: Short call spreads on HAL and SLB.