Oil prices reached a new post-crash high on Friday, topping $40 a barrel. The ongoing rebound has helped energy stocks tremendously, but we’re starting to see a disconnect between the two. While crude continues to ramp, companies like Exxon Mobil (NYSE:XOM) and BP (NYSE:BP) are seeing their share prices sputter. Fortunately, with options contracts, we can build a position that profits even if BP stock remains rudderless.
Before we dive into the magic of derivatives, however, let’s first analyze the price action in oil and BP to identify the trends and price levels that matter.
Oil vs. BP Stock
Perhaps the easiest way to compare two different assets is with a chart overlay. We can plot oil prices on the same graph as BP stock to measure the degree to which they are correlated. When they move together, we say the correlation is positive. When they move apart, it’s negative.
The accompanying graphic plots oil prices using a purple line chart. BP shares are displayed via candlesticks. You’ll notice they generally follow each other throughout the past year. However, there are occasional periods where they diverge, and the relationship breaks down. We’re in one of those times now. Over the past few weeks, oil has remained bullish, even rising to new multi-month highs. At the same time, BP stock has fallen to a two-week low.
As a result of the disconnect, the correlation coefficient has dropped near zero. If the past is prologue, then this is likely a short-term phenomenon. BP stock will start rising to catch-up with oil, or crude will crater to follow the weak path of BP. Because we’re going to build a bullish leaning trade, I’m hoping its the former resolution.
The mid-March launch off the lows sparked what could have been a powerful multi-month rally. But, all BP’s stock has done since then is tread water around $24. Earlier this month, buyers scored a breakout that pushed the stock as high as $28.57. Unfortunately, it turned into a bull trap, and we find ourselves back to inching sideways at $24 again.
The 50-day and 20-day moving averages are flat as a pancake and confirm the stock’s neutrality. When prices are at a stalemate like this, directional trades are challenging. No one wants to buy a stock only to see it hibernate for weeks on end. Traders have two choices here. Either wait for BP stock to break out of its range by piercing $26 or $21, or build an options strategy that profits even if prices remain neutral. Let me show you how.
Covered Calls for the Poor
One of the most popular trades using options is the covered call. It involves buying 100 shares of stock and selling a call option. The trade can get expensive because you have to purchase shares. The large capital outlay also makes the potential return on investment tiny.
To supercharge the reward, however, we can substitute long stock with an in-the-money call option. It will act as a proxy for the stock and give us a similar profit zone to the covered-call position. The strategy is known as a poor boy’s covered call.
The Trade: Buy the Aug $20 call, while selling the July $25 call for a net debit around $3.70.
The $370 cost is far cheaper than the $2,300 required to buy stock and represents the max loss in the trade. If BP rises to $25 and beyond, your max profit is around $130, which translates into a 35% return. That’s roughly 10x what it would have been in a traditional covered call. Even if BP stock stays put at $24, you’re still able to scratch out $37 or a 10% gain.
For a free trial to the best trading community on the planet and Tyler’s current home, click here! As of this writing, Tyler held bullish options positions in XOM.