Rising Energy Prices Could Lead To 70% Gains With This Stock

Monday, March 10, 2014 - 2:30pm

by Alan Knuckman

Energy prices are on the move once again. Crude oil is at five-month highs and solidly above $100 a barrel. And natural gas hit multiyear highs with severe cold weather across North America and no end yet in sight to this record-breaking winter. Add in the macroeconomic picture of increased demand worldwide, and it's likely that this bullish trend will continue.

Transocean (NYSE: RIG), which provides offshore contract drilling services for oil and gas wells around the globe, has been trading sideways in a $20 trading range from $60 to $40 since August 2011. This two-and-a-half-year channel has held support at $40 so far in 2014, with a new 52-week low made this week just above $41.  

Traders should note that this new low did not coincide with new highs in volatility, and a bullish divergence such as this is often a sign of price stability and could mark a bottom after a long-term decline. RIG has long-term support at $38 dating back to December 2011.

RIG is surely a market laggard, down 16% during the past 52 weeks, which is in sharp contrast to the record run in most stocks over the past year. But it could make a big move higher as energy prices continue to rise and shares play catch up.

The midpoint of the large, two-year-plus trading range discussed above sits at $50. Additionally, the shorter-term $56 to $44 range also has a midpoint target of $50.

The $50 target is about 16% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could make 70% on a move to that level.

One major advantage of using a long call option 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.

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 a call 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 RIG trading near $43 at the time of this writing, an in-the-money $33 strike call option currently has about $10 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 90.

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 RIG Jan 2016 33 Calls at $10 or less.

A close below $38 in RIG 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 $1,000 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2016 options give the bull trend almost two years to develop.

This trade breaks even at $43 ($33 strike plus $10 options premium). That is only a few cents away from RIG's recent price. If shares hit the $50 target, then the call option would have $17 of intrinsic value and deliver a gain of 70%.

Action to Take -->

-- Buy RIG Jan 2016 33 Calls at $10 or less
-- Set stop-loss at $5
-- Set initial price target at $17 for a potential 70% gain in 22 months

This article originally appeared on ProfitableTrading.com:
A $1,000 Bet on This Offshore Driller Could Land Traders 70% Profits

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Alan Knuckman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.