Taking a LEAP Into the Oily Bottom

The bottom is in for oil...or maybe not, but many are feeling confident to call the bottom, and while I track the price of black gold, I don't have a strong opinion yet that the carnage is over. The decline has been painful, at least for producers, but my gut tells me that too many are still too willing to jump in too soon. Typically, bottoms happen only after three tests of the lows, and the early believers get their heads handed to them. (See the 2002/2003 stock market bottom for a classic example of the pattern; the S&P 500 took three shots to break to the downside before the end of the bear market had arrived.) There are no certain rules in investing, of course, and I acknowledge that I could be wrong to not embrace the turn, but my position today is not constructive or destructive, just that my opinion is not strong. What I do feel strongly about, however, is that if you want to play the bottom in oil -- whether we are there today or it comes a year from now -- the best trade structure is one I first recalled in this post last December. Using way-out-of-the-money long-term call options (LEAPs) on stocks that have cratered is a highly levered, but low risk, way to juice your return. When you buy a call option that is far out of the money, the premium is quite small, and you can take an outsized position, relative to the capital you commit. By using LEAPs, you give yourself 18 to 24 months for the thesis to play out. (This is critical -- most option trades expire worthless because time is the enemy of your thesis.) You can only execute this structure against down-and-out names or sectors, because only stocks with large and rapid declines will have options outstanding with a high strike price. (The CBOE normally only creates contracts with strikes near the current price.) The second prerequisite is that the name or sector must have a good chance of bouncing back -- for obvious reasons. In the 1990s I did these trades on tech stocks that would crater on a bad quarter, then bounce back six months later. Nowadays, there are less sectors with such inherent volatility, but the decline in oil has offered up these sorts of opportunities in droves. I am looking at energy names directly, as well as underserved collateral victims such as solar names: I highlighted this trade in First Solar (FSLR) recently. All that was a long-winded way of saying that if you believe oil has bottomed, or will bottom and rally in the next year or so, you should play the bounce with out- of-the-money LEAPs! Below is a table of many large-cap energy names with their performance over the past six months. Start with the worst and go from there. The pure play shale names such as Continental Resources (CLR) or Southwestern Energy (SWN) are the best bets, as you can open a position for pennies per contract and potentially make multiples of your investment if the stocks rally. (And remember they do not have to get to the strike price; if they simply go up, the option price will rise and you can sell the contract for a profit.) Oil Patch Stock Performance View Chart » Note the names that are not of interest: the refiners! They held up exceptionally well during the decline, because they are spread businesses rather than direct sellers of the commodity. In general, if oil turns, any of the dog names at the top will be huge winners in this option trade, so do some research but don't feel the need to be too picky.

Taking a LEAP Into the Oily Bottom

If you're inclined to play a bottom, here's a way to juice returns.

Columnist Conversation

Mr. Buffett Said: 'I couldn't find anything worth buying'

Thoughts on Stocks, Credit and the Reopening

Large CEO Buy Last Week in Essent Group (ESNT)

COLUMNIST TWEETS

Please Join or Log In to manage and receive alerts.