Playing ConocoPhillips for a Bounce with a Call Spread Risk Reversal

August 8, 2014 10:15 AM

The refining stocks had been building pressure to the upside until the market turned lower last week.  They were getting a bit overbought so maybe this is a good thing to reset their risk and get ready for the next leg up.  One in particular in the space, CononcoPhillips, $COP, seems to be resetting well.  But when will it stop falling?

The chart above shows that the RSI, a measure of momentum, has pulled back substantially on this weekly timeframe, and the price is near the 20 week (or 100 day) SMA.  But it is hard to buy this stock with the long red candle from last week looming out there and support down near the 50 week SMA and the prior peak at 74.  It would be a lot nicer to buy it on a bounce there.  But what if it does not get there?  Missing an opportunity to buy it at 79 would be horrible if it moved back higher.  So what to do?

The options market gives you an opportunity to participate in an upward bounce without any risk on the downside until that 50 week SMA.  Using something called a Call Spread Risk Reversal, you can get in now and not ave to wait to see what the stock price does.  A Call Spread Risk Reversal is just a combination of options.  The Call Spread is a long Call paired with a short Call of a higher Strike and the same Expiry.  This is where the upside participation comes from.  Selling an out of the money (OTM) Put makes it the Risk Reversal, as it adds downside risk.  For this stock at November 82.5/90 Call Spread will give $7.50 of upside.  This was priced at about $1.60 as I write this.  And for the downside, selling a November 72.5 Put, priced at $1.22, brings the price down to less than 40 cents.  It does expose you to owning the stock below 72.50 but isn’t that where you liked to own it anyway?

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