The oil market pulled back on Monday after speculators took money off the table. I am still bullish. Inventories are low. Capital is in short supply. I am looking for a top oil trade.
I’ve laid out my thesis that the global market will experience a significant investment gap in the next four years. It bears repeating. There is a $500 billion problem – first laid out by JPMorgan and Moody’s.
There’s a strong chance that crude prices hit $150 or even $200 in the next few years based on the lack of capital in the market. The cost of capital in the energy production space has jumped from 8% to 20% since 2008. It’s going higher. I would say that $130 is more rational. But the points remain in place.
I know that I can’t time the market. And I know that I can’t predict what oil prices will do – next week, two months from now, or even a year from now. However, I can look at a range of probabilities and use recent price movements to my advantage. Let’s talk about how to make some money in a high probability trade around oil.
Cash Secured Probabilities
I’ve discussed the merit of selling cash-secured puts in the past. This allows you to pick a specific strike price and a specific date for a stock you want to own. Take Devon Energy (DVN). The company just reported strong earnings and increased its dividend by 22% on Monday. 22%.
Now that earnings are out of the way, I want to make some money. So, let’s look at the September 16, 2022 $55 put. It’s trading under $2.60. In this case, I would need $5,500 in margin to sell this cash-secured put.
It would generate a credit of $260 ($2.60 times the right to 100 shares). If the stock drops under the strike price on or before September 16, and the put buyer assigns the stock to me, I would take control of all 100 shares.
My “maximum” risk is $5,240. We would deduct the credit from the margin requirement. Naturally, the maximum risk is that the stock’s price would fall to zero.
Remember, the odds of this occurring are extremely low. But you can assess your probability of profit on this trade, the total return expected, and your total upside.
In this case, this trade grants me a 79.5% probability of profit. If the stock remains above $52.40 by September 16, I will profit. If the stock goes higher and the value of the put decreases, I can repurchase it and pocket the net between my sale and my repurchase.
And if the stock stays above the strike price on the expiration date, I get to keep all $260. Pretty great. But there is a number here that’s rather dull. My maximum return is roughly 5% on my money. That’s lower than the dividend. So, let’s add another leg to this trade.
Credit Spread Top Oil Trade
Instead of just selling the $55 put, I can purchase the $50 put as protection and define my risk. Best of all, I require FAR less margin. If I own the $50 put on the same strike date, I no longer have any risk if the stock falls under that price level on or before the expiration date.
Instead, my maximum risk ties to the margin requirements between the $50 price level and the $55 price level. I’m engaging in a “Credit spread.” By selling a put at a lower level and then buying one further out of the money, I will receive a credit for the difference between these two prices.
So, if the September 16, 2022 $55 put trades at $2.60, the September, 2022, $50 put trades for $1.27. The credit, in this case, would be $133 to the seller.
The maximum risk is $500 minus the credit received – or $367.00. But check this out. The potential return here is 36% in less than 46 days (or 281% annualized).
And the probability of profit remains a hefty 75.8%. So you’re taking on just a bit more risk to profitability while reducing the potential downside of the trade. And again, if the stock falls under $55, you will be assigned the stock.
If it falls under $50, you have the extra protection to dump shares… I love this trade right now.