Daily Gains Letter

Investment Opportunity in $50 Oil?

By for Daily Gains Letter |

Investment OpportunityOil prices are in a dark area now, as the commodity is considered the dirtiest of all commodities at this time.

With no strong base in sight for oil prices, we could see additional downside moves; albeit, $50.00 looks like a pretty good area for support.

On the chart of the West Texas Intermediate (WTI) crude, oil prices fell to the $53.00 level earlier this week but managed to stage a small rally back to $55.00–$56.00.

Light Crude Oil Chart

Chart courtesy of www.StockCharts.com

I’m not fully convinced oil prices will hold at the mid-$50.00 level and feel a move towards $50.00 could be in the works. But this may not be bad news for all investors. Before I get into the potential investment opportunity, though, it’s important to understand the supply-demand dynamics behind the fall in oil.

Supply-Demand Imbalance in Oil

The supply, or production, of oil is much higher with the free-flowing shale oil from North Dakota and the fact that the Organization of the Petroleum Exporting Countries (OPEC) refuses to cut its production despite calls for action coming from Iran and Venezuela. OPEC suggested it will be an onlooker and has no interest at this time in cutting production and giving oil prices some support. The oil cartel blamed part of the oil price weakness on speculation. So, yes, oil traders have to take some of the blame for the declining oil prices and the increasing supply is a definite factor.

However, we also have the slowing global economy and the resultant decline on the demand side. The International Energy Agency cut its global demand outlook for the fourth time in five months. And OPEC cut its oil demand for 2015 to the lowest level in 12 years.

The end result has been chaos in the energy market, with many oil stocks losing 50% or more of their value in a short period of time, which breeds a potential aggressive investment opportunity.

At this point, there is no guarantee oil prices will not move lower.

The Investment Opportunity in Weak Oil Prices

Aggressive traders may look at adding call options on energy stocks on the major weakness. I suggest an expiry in January 2016, as the option premiums are not too expensive at this time for the calls and this will allow oil stocks time to rally.

Options traders are bullish on oil prices going forward, but not as much as a straight call options buyer, who could establish a double-legged bullish call option spread. In this case, you buy a call option with a lower strike, and sell a call option with a higher strike but the same expiry. The selling of the higher call option generates some premium income that helps reduce the cost of the trade.

Under this scenario, you make money once the stock crosses above the lower strike. Profits occur until the price of the stock hits the higher strike price. This naked call is covered by the call on the lower strike. Make sure both options are held for the trade to work.

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