The oil trade has puzzled most experts. To me, it is clear that crude oil is range bound between two fundamental dams. The first is when oil rises above $50. It becomes bad for OPEC members, so they talk the price down. Conversely, as it falls to the low $40s, they talk it up to protect their pocketbooks. These are not hard lines in the sand, but they make up a clear tradeable range.
Energy stocks are closely tied to the oil prices. So when I trade stocks like Chevron Corporation (NYSE:CVX) I have to consider oil prices in addition to the equity market macro. Right now, oil is just above a balance point. which leaves an opening to trade.
So with so many variables at play, I restrict my trading of energy companies to the major like CVX, Exxon Mobil Corporation (NYSE:XOM) and ConocoPhillips (NYSE:COP).
In the past two week, CVX stock suffered a 5% correction after a double top on Aug. 10. Luckily it had benefited from an incredible rally last fall. So this leaves Chevron stock still up 4% in the past 12 months. Since I believe in balance, this seems like an opportunity to sell downside risk for income while it’s at a 12 months mid-range point.
I have two primary assumptions to my bullish thesis today. The first is that the equity markets in general will not suffer a major correction this year. The second is that I am willing to own CVX stock at a discount from current levels.
Chevron is not cheap from a price-earnings perspective, but that is an instance of its sector. These companies are in the process of adjusting their operations to the new normal in oil prices. The company’s price-book ratio is 1.40, so owning it lower is not likely a mistake. This gives me a level of comfort while selling short-term downside risk into it.
Click to Enlarge Over the past five years, CVX has pivoted around the $100 level within +/- $35 per share. This is to further support the idea of balance in the stock. I believe that over time, traders tend to overshoot in either direction and somewhere in the middle lies the truth.
Since today I will be selling risk, I want to consider the possibility of the worse-case scenario and account for the possibility of it reoccurring. That’s why I use options to trade CVX stock. There I can reduce the need to be perfect with trade timing.
I sell puts against what others fear and create income out of thin air. Because I am taking a risk, the money flows into my account to open the trade. CVX has challenges otherwise they’d be no reward for me and therein lies the opportunity I seek.
The Trade: Sell the CVX stock Dec $95 naked put and collect $1.20 to open the risk. Here I have an 85% theoretical chance that price will stay above my strike. Otherwise I own the shares and could suffer losses below $93.8 per share.
Those who want to mitigate the risk that comes with selling naked puts can sell spreads instead. There the maximum loss is much smaller than the trade above.
The Alternate Trade: Sell the CVX stock Dec $95/$90 bull put spread where I risk less yet still can profit with 10% in yield.
In either case it is important to note that I am not buying the shares and hoping for a 10% rally. All I need to profit is for CVX not fall more than 10% from these already low levels. I come into this trade with profits in pocket from this recent winning trade.
Remember: Investing in the stock market doesn’t come with guaranteed results, so never risk more than you can afford to lose.
Learn how to generate income from options here. Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities. You can follow him on Twitter at @racernic and stocktwits at @racernic.
