A Free, Lower-Risk Trade on a Strong Stock

Trade Strong Stocks

This afternoon, The Wall Street Journal interviewed Fed Chair Jerome Powell. Looking at a basic chart of the S&P 500, you can see the candles where the markets initially disliked his comments…

Chart, line chart

Description automatically generated

And then swung back positively toward the end of the session. 

Momentum remains in red territory, but we’ve seen accelerated purchasing across various sectors. As a result, there has been a dramatic improvement on one side and a substantial decline in the number of stocks dropping like stones. 

With that said, the market continues to witness many stocks hit new 52-week lows. Today, 236 companies had reached new lows heading into the final hour of trading. On the other hand, we witnessed 66 companies hit new 52-week highs. So what is rallying to new 52-week highs… and should we buy?

What’s Working Well?

Many biotech giants appear on the list of new highs in Bristol-Myers Squibb (BMY) and Merck (MRK). In addition, given labor shortages, we see a few staffing agencies in DHI Group (DHI) and Hudson Global (HSON). And several names are evident in the packaging sector. 

But the most significant movers to the top are in the shipping and the oil supply chain. 

And when you think about what’s happened in this market, both sectors continue to exhibit incredible strength. The weakness in the global supply chains has allowed shipping giants like Golden Ocean Group (GOGL), Star Bulk (SBLK), and International Seaways (INSW) to hit new highs – and their upside remains remarkable given their substantial dividends and low multiples.

But that’s just three companies. I counted 24 companies in the energy supply chains hitting new highs. 

This list includes the traditional exploration and production giants that I’ve named in the past here in Haven Investment Letter as favorites. They include Devon Energy (DVN), Occidental (OXY), ConocoPhillips (COP), and Pioneer Natural Resources (PXD). 

Integrated majors like Chevron (CVX), Exxon Mobil (XOM), and Shell (SHEL) are also hitting new highs. 

But the biggest is the strength in the refineries. HF Sinclair (DINO), Marathon Petroleum (MPC), Phillips 66 (PSX), and Valero (VLO) continue to scream higher. 

These companies continue to benefit from record-high prices in gasoline and refined products like diesel and jet fuel. Heading into the summer months, many analysts project that a shortage of diesel will hit the Eastern U.S. supply chains, particularly in the Northeast. 

As a result, markets anticipate significant demand for refineries. But there’s terrible news… most refineries are shipping products to Mexico to sell them. The reason? Bad U.S. energy policy. 

No Reform Coming 

Most people recall that the Biden Administration killed the Keystone Pipeline, which would have shipped Canadian crude to the Gulf Coast refinery network. While the Keystone has been a political football for my 12 years in energy policy, I remind people that the Keystone pipeline wouldn’t relieve the bottlenecks in the U.S. energy supply chains. 

Refineries have little way to move refined diesel to Northeastern states with ease. In addition, we don’t have the pipeline infrastructure to ship products north where demand is high.

What’s worse? We can’t prevent the bottlenecks by sea either due to a 1920s law called the Jones Act. That post-World War I law mandates that all ships moving products from U.S. port to U.S. port must be owned and crewed by Americans. 

Without enough ships and by barring foreign flags, we limit our ability to move crude. It would make almost too much sense to eliminate that law, but it’s clear that someone has been entrenched for more than 100 years and doesn’t want to give up that market power. 

We can’t expect that law to disappear or for it to be suspended any time soon, so diesel fuel (which remains in extremely high demand in Europe and at higher prices) will remain elevated here in the United States for the foreseeable future. 

How to Trade the Refineries

Anyone looking for a way to trade stocks at 52-week highs might consider buying calls on these high-flying stocks. But remember, the further you go out of the money, the lower your probability of profit will be. 

Instead, I prefer to trade a credit spread at much lower levels. I can set a price that I’m willing to pay should any of these stocks fall lower. I can sell a put on the stock at a price I’d be willing to pay. 

But instead of requiring a full margin of what 100 shares would need at that specific strike price, I can cover the potential downside by building a spread. I purchase a similar put at a lower strike price on the same expiration date. 

So, let’s look at trading Valero Energy. In this scenario, you would see that shares trade at nearly $128. That means you’d need about $12,800 to own 100 shares. 

If you sell a cash-secured put for 100 shares on June 17, 2022, $110 put, you would need $11,000 in the margin to generate that trade. And, you’d only obtain a credit of $130 (100 shares at $1.30 in the contract). That’s barely a 1% return on your money… and if the stock collapses under $110 for any reason, you’d be on the hook for the difference between the strike price and the settled price on the date of expiration. 

But what if you could protect your maximum downside and generate an excellent return on your capital in the process. That’s where the spread comes in. 

How To Trade VLO

In this scenario, you would sell the VLO $110 put on June 17, 2022, for $1.35. And you would buy the VLO $105 put for June 17, 2022, at about $0.85. This would give you a credit of $55 (100 shares time the spread of $0.55)

In addition, you would need $450 of margin because your maximum downside is defined by the $105 put that you are buying. In this trade, you are looking to generate the full credit of $50 from your $450 in risk. That represents an 11.1% return by June 17, annualized to 127%. 

If Valero finishes at or below $110 on the date of expiration, you have an obligation to purchase the stock. Of course, you can always sell that contract back to the market ahead of time but remember that you aim to generate income off the spread. 

Finally, based on the historical patterns, this VLO trade has an 89.2% probability of profit. In times like this, I want to trade low-risk with double-digit upside. These spreads are how I prefer to trade when market momentum is negative. 

We take what the market gives us in solid sectors and give us a second chance to buy up strong names if the stocks experience a pullback. I’ll be traveling to Chicago this week for a few projects. I’ll let you know if anything significant happens when I visit the CBOE.

Garrett Baldwin
Garrett Baldwin
Garrett Baldwin joined Godesburg Financial Publishing as Chief U.S. Markets Analyst in early 2021. A Johns Hopkins-trained Economist, he’s worked with hedge funds, venture capital firms, angel investors, and economic advisors to the U.S. government. Baldwin specializes in market anomalies and alternative investments. He’s written extensively on momentum, value, insider buying, and other unique strategies that provide investors that elusive edge.
Garrett Baldwin
Garrett Baldwin
Garrett Baldwin joined Godesburg Financial Publishing as Chief U.S. Markets Analyst in early 2021. A Johns Hopkins-trained Economist, he’s worked with hedge funds, venture capital firms, angel investors, and economic advisors to the U.S. government. Baldwin specializes in market anomalies and alternative investments. He’s written extensively on momentum, value, insider buying, and other unique strategies that provide investors that elusive edge.

Related Articles

cheap stocks

What’s Cheap Right Now?

Market momentum is Red. The markets closed the week in positive territory after a late-Friday rally helped push stocks higher. Heading into next week, investors

Read More »
cheap stocks

What’s Cheap Right Now?

Market momentum is Red. The markets closed the week in positive territory after a late-Friday rally helped push stocks higher. Heading into next week, investors

Read More »