Call Spread: National-Oilwell Varco (NOV)

by Tyler Craig | October 14, 2013 1:56 pm

Amid last week’s rapid stock market rebound the SPDR S&P Oil & Gas Equipment & Services ETF (XES[1]) soared to yet another new high for the year. Since many sectors and industries still languish below their high-water marks for 2013, XES is showing its ability to lead the pack. Relative strength is quite the attractive quality for any security participating in the daily popularity contest that is stock picking.

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Unfortunately, while XES has been a serious contender in the outperformance category, it’s been utterly lacking in the liquidity department. On average, the energy-based fund trades a paltry 50,000 shares a day. While long-term investors may be able to justify snatching up a few shares of the fund, the inactivity of its listed option contracts makes it ill-suited for any option plays.

Fortunately, a number of stocks within the ETF do present alluring opportunities for option trades.  Take National-Oilwell Varco (NOV[2]) for instance. The stock sits in a healthy uptrend atop a rising 50-day moving average. It’s spent the last month digesting recent gains in a solid looking base between $77 and $80. A break above $80 may well signal the next advance in NOV is beginning.

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The action in NOV becomes even more appealing when considered from a volatility perspective. A stock’s volatility tends to move in cycles between compression and expansion with one eventually giving way to the other. For example, the volatility expansion from $71 to $79 in late-August to early-September transitioned to a period of volatility compression, which saw the stock consolidate in a tight range.

The ongoing volatility constriction is easily seen in the behavior of the Bollinger band (BB) indicator, which has narrowed aggressively in recent weeks.  In fact, the squeeze in the bands has lowered the BB width — which measures the distance between upper and lower band — to its lowest levels of the year at $2.84.

Like a coiled spring, the contraction in NOV volatility will eventually give way to a large move in one direction or the other. If the overall trend is any indication, the breakout will likely take place to the upside.

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One strategy to exploit a renewed advance is to purchase the NOV November 77.50-82.50 call spread by buying the 77.50 call and selling the 82.50 call for a net debit around $2.50. The max loss is limited to the initial debit paid and will be incurred if NOV sits below $77.50 at November expiration. The max reward is limited to the distance between strikes minus the net debit, or $2.50, and will be captured if NOV sits above $82.50 at November expiration.

If you seek more confirmation before entering you could wait until NOV breaks above $80. Keep in mind NOV does report earnings on October 25.

At the time of this writing Tyler Craig had no positions on any of the aforementioned securities.

  1. XES:
  2. NOV:

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