How To Generate High Returns In A Risky Sector… Without Losing Your Shirt

Many oil explorers and producers (E&P) are on the precipice right now. Years of high oil prices have led to a bonanza of land grabs and acquisitions despite premium valuations. Companies took on high levels of debt, reasoning that the revolution in U.S. production would mean cash flows could easily cover the interest.

But now that oil prices have been cut in half, nearly $11.6 billion of that debt could be at risk of default.

This earnings season, companies are expected to announce major changes to their capital spending plans to control the cash bleed while analysts continue waiting for a sign that the energy market has bottomed.

All the uncertainty means high risk for investors… but also the potential for high returns for the companies that can survive until energy prices recover.

#-ad_banner-#I am not naive enough to try calling a bottom in energy prices, but with this option trade, I don’t have to. In fact, today’s trade can give you the opportunity to minimize risk and amplify any potential returns, all while preserving capital if the trade doesn’t work out.

Don’t Gamble With Your Money… Use Options to Minimize Risk and Preserve Capital

The E&P space definitely has the potential to shoot higher on any improvement in oil prices or investor sentiment. Unfortunately, the potential for return is balanced by the risk that either of those factors may take longer than expected to materialize.

OPEC continues to give conflicting messages about whether it will announce a supply cut at its June meeting. Several of its member nations desperately need higher prices to balance budgets, but the cartel is struggling against booming U.S. production.

Options can be an investor’s best bet for these high-risk, high-reward trades. SPDR S&P Oil & Gas Exploration & Production ETF (NYSE: XOP) has plummeted 37% since its June 2014 high, and some names in the sector are looking increasingly attractive. While oil prices seem to have bottomed earlier in the year, value investors still risk sizeable losses if their picks succumb to debt loads and default.

Buying call options limits risk by limiting the amount of capital you need to commit to a trade. Investors can buy calls on an underlying security for a fraction of what the actual investment would be. For example, call options on XOP with a strike price of $45 expiring in January 2016 sell at a premium of just under $9 per share. Your breakeven price is a little higher, about 3% above current prices, but the position costs less than a fifth of what a traditional stock purchase would cost.

If the market drops out of oil prices again, your losses are limited to the $9 premium paid, protecting your capital from the proverbial falling knife of value investing.

Using Options to Amplify Returns

With call options, not only are you limiting your risk, you also have the opportunity to amplify returns.

This is a strategy that my colleague Jared Levy has been sharing with investors in his Profit Amplifier service. Jared was one of the first to bet on a stronger dollar last year by buying calls on PowerShares DB US Dollar Index Bullish Fund (NYSE: UUP). His trade setup turned a 2.7% move in the fund into a 71% return in less than a month.

If OPEC decides to support the market with a supply cut or at least talks prices higher during its June meeting, investor sentiment could improve quickly, which means prices for E&P stocks could jump.

If XOP rises to just $60 a share — still 28% off last year’s high but 13% higher than current prices — the January $45 call options could yield a 60% return.

That’s a great trade… but right now, I see an even better setup emerging in the sector.

Amplify Your Return on Best of Breed in a Shaky Industry

A call on the E&P sector fund may play out if oil prices increase, but I like an individual company better for this trade. Chesapeake Energy (NYSE: CHK) is a best-of-breed company in the E&P space, meaning that it could rise even if the rest of the market continues to struggle.

A lot of the company’s strength comes from the fact that it started to introduce financial discipline before energy prices started to fall. Long-time CEO Aubrey McClendon was ousted in June 2013 and replaced by ex-Anadarko executive Doug Lawler. The new chief immediately stressed financial discipline after the old guard had run up debt through heavy spending.

It was this eye for a healthy balance sheet that has saved the company. While other E&P companies kept spending heavily for another year, Chesapeake cut back and became more efficient.

Now, while the rest of the industry scrambles to cut costs, Chesapeake’s discipline is paying off. The company booked an operating margin of 18.9% in the final quarter of 2014, well above others in the space. Over the same period, competitors Anadarko Petroleum (NYSE: APC) and Apache Corporation (NYSE: APA) both booked negative operating profits.

Chesapeake has shifted to oil and liquids-rich plays over the past year, but the company is still heavily tied to natural gas production. An albatross over the past five years, this may end up benefiting the company in the short term: A hot summer in the United States would increase demand for air conditioning, which could help natural gas prices find upward support.

Over the next year, liquefied natural gas (LNG) exports will start to come online, starting with Cheniere Energy (NYSE: LNG) and more companies following later. The immediate increase in exports may not be material in scale but could drive investor sentiment higher.

The company has just $285 million in debt, interest and purchase obligations maturing this year, which should be easily covered by cash flow. Cash flow from operations was $829 million in the fourth quarter alone, and the company should have plenty of liquidity to outlast any near-term weakness in energy.

With Chesapeake trading a little below $15 a share, we can buy the CHK Jul 14 Calls for $1.99 per share ($199 per contract). That’s a call option on CHK with a $14 strike price that expires in July. The trade breaks even at $15.99, just 7% higher than current prices. Any rebound in sentiment could send the stock back to $17.69, the January low before the February sell-off.

At $17.69 per share, our call options would be worth at least $3.69 a share for an 85% return in less than four months. Once you enter the trade, place a good ’til cancelled (GTC) order to sell your calls at that price.

The July expiration encompasses several key events and gives us plenty of time for the trade to turn a profit. The expiration will include the company’s first-quarter earnings release in May, as well as the June OPEC meeting. Summer weather could heat up by July and send natural gas prices higher, and we will start to see second-quarter earnings roll in. All of these events have the potential to take the shares higher and amplify the gains on our trade.

Recommended Trade Setup:

— Buy CHK Jul 14 Calls for $1.99 or less
— Set price target at $3.69 for a potential 85% gain in four months

If you’re interested in receiving more profit amplifying options trades, you can read a short fact sheet about Profit Amplifier here. This not a promotional video or anything like that; it’s a document that takes about three minutes to read and outlines everything you need to know about world-renowned options strategist Jared Levy’s unique options buying strategy. Follow this link to read it now.

This article was originally published on How to Generate High Returns in a Risky Sector… Without Losing Your Shirt