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Oil Stock's Breakout Could Land Traders 45% in the Next 6 Months
Crude oil prices have stayed above the psychological $100-a-barrel level for almost two full months. The Energy Select Sector SPDR (NYSE: XLE) has recovered to $82, within striking distance of the 2008 peak above $88.
Schlumberger (NYSE: SLB) is the world's leading supplier of technology, integrated project management and information solutions to customers working in the oil and gas industry.
The stock's current breakout of the nearly year-long channel largely between $70 and $80 targets a move to $90 a share in the longer term. In the near term, a push above the $80 to $84 month-long action projects a $4 move to $88. Additionally, a bull flag pattern is nearing a breakout on the upside.
SLB has solid technical support at the $70 level, near the April and June lows.
The $90 target is about 10% higher than current prices, but traders who use a capital-preserving, stock substitution strategy could make almost 50% on a move to that level.
One major advantage of using long call options rather than buying a stock outright is putting up much less capital to control 100 shares -- that's the power of leverage. But with all of the potential strike and expiration combinations, choosing an option can be a daunting task.
Simply put, you want to buy a high-probability option that has enough time to be right, so there are two rules traders should follow:
Rule One: Choose an option with a delta of 70 or above.
An option's strike price is the level at which the options buyer has the right to purchase the underlying stock or ETF without any obligation to do so. (In reality, you rarely convert the option into shares, but rather simply sell back the option you bought to exit the trade for a gain or loss.)
It is important to buy options that pay off from a modest price move in the underlying stock or ETF rather than those that only make money on the infrequent price explosion. In-the-money options are more expensive, but they're worth it, as your chances of success are mathematically superior to buying cheap, out-of-the-money options that rarely pay off.
The options Greek delta approximates the odds that an option will be in the money at expiration. It is a measurement of how well an option follows the movement in the underlying security. You can find an option's delta using an options calculator, such as the one offered by the CBOE.
With SLB trading at about $81.90 at the time of this writing, an in-the-money $70 strike call option currently has $11.90 in real or intrinsic value. The remainder of the premium is the time value of the option. And this call option currently has a delta of about 85.
Rule Two: Buy more time until expiration than you may need -- at least three to six months -- for the trade to develop.
Time is an investor's greatest asset when you have completely limited the exposure risks. Traders often do not buy enough time for the trade to achieve profitable results. Nothing is more frustrating than being right about a move only after the option has expired.
With these rules in mind, I would recommend the SLB Feb 70 Calls at $13.75 or less.
A close below $80 in SLB on a weekly basis or the loss of half of the option's premium would trigger an exit. If you do not use a stop, the maximum loss is still limited to the $1,375 or less paid per option contract. The upside, on the other hand, is unlimited. And the February options give the bull trend six months to develop.
This trade breaks even at $83.75 ($70 strike plus $13.75 options premium). That is less than $2 above SLB's current price. If shares hit the $90 target, then the call options would have $20 of intrinsic value and deliver a gain of 45%.
Recommended Trade Setup:
-- Buy SLB Feb 70 Calls at $13.75 or less
-- Set stop-loss at $6.87
-- Set initial price target at $20 for a potential 45% gain in six months
For more analysis on SLB, see the video below (starting at 2:13):
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