Everywhere you look, everyone has gas – and plenty of it. Production has increased, storage tanks are bulging and, after a warmer than usual North American winter, supplies could reach a record high.
Analysts are split on the longer-term outlook for natural gas prices. But what is clear is that the downward price spiral is having a big impact on smaller Canadian natural gas producers. Earnings expectations are being revised downward following a year of stellar gains, and share prices are following suit.
Mid-level names that come to mind include: Celtic Exploration Ltd. (symbol: CLT; recently priced at $14.75 a share), Paramount Resources Corp. (POU; $28) and Progress Energy Resources Corp. (PRQ; $11.28).
Although all three companies’ share prices are down sharply over the past three months, some analysts believe a bottom may have been reached. Typically, stocks bounce along a bottom, building a base for an eventual turnaround. I doubt any of these companies are there yet, but you could make a case for buying and writing call options against the shares. I think of this strategy as a “falling for dollars” trade.
There are a couple of reasons behind this strategy. First, there is the potential contrarian play of buying at a time when so many others are selling. Second, there is the option play linked to the implied volatility of the underlying stock.
On the first point, you must ask whether the pound of flesh that the market already has taken from these companies is enough to discount the bad news. In other words, have these companies overshot to the downside? The challenge is in trying to develop a supply/demand model when so many cross-currents are at play all the time. Not the least of these is uncertainty regarding oil prices and the fact that no one can predict weather patterns accurately.
As for the second point, we have more clarity; it comes down to simple mathematics. We know that as a stock declines, there is an increase in volatility, which is factored into the option premium. In other words, you get higher than average, decent premiums for writing options against stocks that have fallen sharply. In this particular sector, the options are trading at implied volatilities that are in the top quartile of all Canadian companies.
The falling for dollars (i.e., covered call) strategy provides a decent return if the underlying stock remains unchanged or rises slightly. It also provides a cushion for the stockholder, as the premium can be used to reduce the cost of buying the shares. And when implied volatilities are high, traders can write longer-term options against the shares.
With CLT, for example, you could buy the shares at $14.75 and write the July 15 calls (implied volatility [IV]: 39%) at $1 or better. With this trade, the three-month return, if exercised, is 9.1%; the return, if the share price remains unchanged, is 7.3%. The downside break-even price for the stock is $13.75.
For POU, buy shares at $28 and write the August 28 calls at $2.15 (IV: 35.9%). The four-month return, if exercised, is 8.32% – as is the return, if unchanged. The downside break-even price is $25.85.
With PRQ, I would sell an in-the-money call in which your client buys the shares at $11.28 and writes the July 11 calls (IV: 35.6%) at 80¢. The three-month return, if exercised or unchanged, is 4.9%. The benefit of the in-the-money covered call is the additional downside protection – in this case, the break-even price is $10.48. IE
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