Defining Risk in the Energy Stocks

Patrick Ceresna
April 30, 2014
5 minutes read

The Canadian energy sector began 2014 with a bullish advance that has seen many of the stocks rise 20+%. Clearly there is a bullish buzz unlocking the low valuations we have seen on these stocks over the last few years. The big question…is this sustainable?

The Bull Argument:

1. Attractive valuations
2. Attractive dividends on positive cash flows
3. Geopolitically safe at a time when Russia is creating increasing uncertainty on long-term supply

The Bear Arguments:

1. Abundant new supply of energy in America
2. Substantial discount of bitument oil over West Texas Crude
3. Continued issues of transportation and delays in the Keystone Pipeline
4. The price rise in the energy stocks is not being accompanied by a material advance in crude oil prices that remain around $100.00 a barrel

Whether you are bullish on the energy names or not, you must consider the risk and reward of monetizing unrealized gains vs. potential further gains and dividends that could be made from continuing to hold. This is where options can help define certainties that normal investors could never have. Let’s look at a scenario of an investor that owns Canadian Natural Resources.

The investor owns 1000 shares of Canadian Natural Resources (TSX:CNQ). They were originally purchased back in October 2012 at $30.00 a share or $30,000.00 total investment. Since the purchase, the investor has received 6 quarterly dividends that have amounted to $905.00 in dividend income. For over a year, the investment resembled dead money as CNQ did not initially participate in the material bull market south of the border. But our investor has now been well rewarded for his/her patience as the last 6 months have brought about a very robust bull advance that has share prices exceed $45.00, or over 50% higher from the original $30.00 average cost base.

Any investor that has been around the block knows that all stocks go through peak and trough cycles. If given enough time, investors will begin a healthy profit taking cycle. So let’s debate the investors situation. First off, there is the potential that CNQ can continue to advance higher and exceed $50.00 per share. At the same time, the stock can easily give back 50% of the advance, something the stock demonstrated in November 2012, June 2013 and August 2013. These profit taking pull-backs are not necessarily fundamentally driven, but rather the natural course of price moment in the process of investors buying and selling. If the stock was to begin one of these profit taking cycles, it is not out of line for there to be a $5-$10 pull-back in the stock, which could result in a $5,000-$10,000 swing in market value of investment.

So, if the investor chooses to remain invested, they will continue to benefit from a quarterly dividend and not have to worry about the tax considerations of the sale of the shares. In addition, there is the potential of further gains. Alternatively, the investors that take the important step of converting paper profits to real profits remove the psychological stress that comes with watching paper profits disappear in an inevitable profit taking cycle.

So what if the investor redefines that trade by collaring the stock? In this case, the investor wishes to secure the stock’s range for the remainder of the year. At the time of this article, CNQ is at $44.60. The investor buys a January 2015 $44.00 put option for $3.00 per share, or a $3,000.00 cost. This put option guarantees that the investor can, under any circumstances, sell the shares at $44.00 over the remainder of the year. To offset that cost, the investor sells a January 2015 $50.00 covered call for $1.10, or a $1,100.00 income.

So what has the investor accomplished?

  • The investor does not need to initially worry about any tax considerations for selling the shares
  • The investor continues to collect the dividends for the remainder of the year
  • The investor is guaranteed $14.00 or $14,000.00 in capital gains profits if the stock reverses
  • The investor continues to have the upside to $50.00 per share (further $5,000+) and can roll up the strike if the investor feels there is room for even further gains
  • All of this is achieved for a fixed upfront net cost of $1,900.00.

This may not appeal to all investors, but for investors that prefer less stress, this options strategy (at a cost) can help create those certainties. Certainties that the stock market alone cannot give.

Patrick Ceresna
Patrick Ceresna http://www.bigpicturetrading.com

Derivatives Market Specialist

Big Picture Trading Inc.

Patrick Ceresna is the founder and Chief Derivative Market Strategist at Big Picture Trading and the co-host of both the MacroVoices and the Market Huddle podcasts. Patrick is a Chartered Market Technician, Derivative Market Specialist and Canadian Investment Manager by designation. In addition to his role at Big Picture Trading, Patrick is an instructor on derivatives for the TMX Montreal Exchange, educating investors and investment professionals across Canada about the many valuable uses of options in their investment portfolios.. Patrick specializes in analyzing the global macro market conditions and translating them into actionable investment and trading opportunities. With his specialization in technical analysis, he bridges important macro themes to produce actionable trade ideas. With his expertise in options trading, he seeks to create asymmetric opportunities that leverage returns, while managing/defining risk and or generating consistent enhanced income. Patrick has designed and actively teaches Big Picture Trading's Technical, Options, Trading and Macro Masters Programs while providing the content for the members in regards to daily live market analytic webinars, alert services and model portfolios.

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