This Trade Could Deliver a 40% Annualized Return

yield-stockphotoThe CBOE Volatility Index (VIX) more than doubled during the past month as concerns over global economic growth and the Ebola virus erased much of the year’s gains in stocks. While the rest of the market is panicking, one group of traders is profiting from the heightened risk.

As risk in the stock market increases, so do option premiums. Higher volatility means higher potential profits for options sellers. In addition, lower stock prices offer the opportunity to buy high-quality names at a discount.

[ad#Google Adsense 336×280-IA]Today, using one of my favorite options strategies, we have a chance to pick up shares of a best-of-breed company at a discount or generate 40% a year in income.

Lower Oil Prices, Not for Long

Few sectors have sold off as much as energy over the past few weeks, as oil and natural gas prices plummeted.

The United States Oil ETF (NYSE: USO), which tracks the price of West Texas Intermediate (WTI) crude through futures contracts, is down 11% over the past month and has fallen more than 20% from its 52-week high in June.

Natural gas prices have also been slammed on weaker sentiment, with United States Natural Gas ETF (NYSE: UNG) down nearly 25% from its June highs.

The weakness in energy prices stands in contrast to projected demand for resources over the long term. In its 2035 Global Energy Outlook, BP (NYSE: BP) estimated global consumption of crude will rise 10.5% by 2025, while natural gas consumption is projected to increase 21.5% over that time.

While the company’s forecast for production growth matches consumption growth for natural gas, total oil production is only forecasted to increase by 9% over the next decade. Just that baseline scenario sets us up for higher oil prices as demand outpaces supply.

As oil prices test $80 a barrel, there is a good chance we’ll see those production forecasts come down as well. Investment in new exploration projects may be cut as oil prices come closer to the level of production costs.

However, if prices do stay low, it could mean a big boost in economic growth, with Citigroup (NYSE: C) projecting global savings of more than $1.1 trillion annually on lower energy costs.

So the recent weakness is setting up an interesting opportunity for investors. If crude and natural gas prices rebound, stocks in the group could follow. And if prices stay low, the savings from energy costs could drive economic growth and send prices higher.

An Industry Leader With Strong Upside Catalysts

EOG Resources (NYSE: EOG) is one of the larger pure play exploration companies in the United States with a market cap of $50 billion. The company has increased production by a compound annual rate of 40% over the past four years, making it an industry leader in organic growth. Management has proven its expertise in finding and developing fields with a 17% jump in proved reserves to 2.1 billion barrels of oil equivalent in 2013.

Across all assets, the company estimates it has more than 15 years’ worth of drilling inventory, including more than 40 years of inventory in the Delaware Basin. That is important because unconventional energy sites tend to deplete at a much faster rate than conventional fields. While production from conventional fields tends to deplete by about 5% a year, shale oil wells can see a production decline of as much as 78% in the first year. To have more than a decade of drilling inventory in reserve means EOG should see relatively strong production for some time to come.

Nearly all (94%) of the company’s proved reserves are in the United States, making it one of the purest plays on the U.S. energy revolution. Only 1% of proved reserves are in Canada, and the company is shifting its focus away from oil sands, which are more expensive to develop. Selling its Canadian assets should unlock shareholder value.

Beyond the upside potential for a divestiture of non-core assets, I like EOG for its conservatism regarding investor communications. Breaking from the industry norm, management does not discuss its new ventures until they reach commercial viability. This removes a lot of the lofty expectations you get in other exploration and production companies and opens the door for upside surprises when EOG releases news of exploration success.

Getting a Discount on a Great Stock

The stock is currently trading 14% off its mid-September highs. With the recent spike in volatility, we can use a put selling strategy to take advantage of elevated option premiums and potentially get a bigger discount. What’s more, we may not even have to buy the shares to book a profit.

By selling a put option on a stock, we are promising to buy 100 shares per contract at the option’s strike price on the expiration date if shares are trading below that strike price. If they are trading above the strike price when the option expires, we don’t have to do anything. Either way, we collect a premium in exchange for taking on the potential obligation.

With EOG trading for $91.22 at the time of this writing, we can sell the EOG Jan 95 Puts for a limit price of $8.40 per share ($840 per contract). If EOG closes below the $95 strike price at expiration on Jan. 17, we will be assigned shares at that price. Since we received $8.40 in options premium, our actual cost is $86.60 per share, a 5% discount to the current price.

Since we may have to buy the shares, we want to make sure we have enough money in our account to cover the purchase. For each contract we sell, we will need to set aside $8,660 of our own capital plus the $840 received from the put sale.

If EOG rebounds and is above $95 on expiration, we keep the $840 premium for a gain of 9.7% over our $8,660 cost basis in just 89 days. If you were able to make a similar trade every 89 days, you could generate a 40% annual rate of return.

Long-term demand for energy and a leadership position in the industry make EOG a solid holding with several catalysts that could send it higher in the near term. With a put selling strategy, we have a chance to generate a 40% per-year return or pick up shares at an additional 5% discount. Either way it looks like a win.

— Joseph Hogue

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Source: Profitable Trading