DAL & OIL: A Pair of Covered Call Plays

Posted on August 19, 2011 by

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Current volatility provides a nice opportunity

Delta Airlines and OIL: Two covered calls that may provide a 5% gain over the next month. The two positions combined offer lower risk than either one by itself.

As of Friday 19 August, 2011…

Performance of Delta (DAL, blue), OIL (red), S&P 500 (yellow), August 5-19, 2011.

Even though the markets have been battered over the last two weeks, Delta (DAL) has outperformed the market. It is also beating the transportation ETF IYT and other airlines like Jet Blue (JBLU) and Southwest (LUV). The reasons for this are for a separate blog, but let’s just say I’m bullish on DAL versus the market overall.

The crude oil ETF OIL is is down with the market, but some pundits feel this is an artificial low for OIL. The view is that the recent drop in OIL is in response to the justified uncertainty regarding the world economy, but that it’s overdone. Crude oil prices have not remained depressed in recessions.

When combined in a portfolio, these two symbols have the benefit of working well together: one tends to hedge the other: As the price of crude oil goes down Delta goes up because the airline’s margin improves directly.

Separately, I think both DAL and OIL are good to own right now because I believe they are both poised to go up. The covered calls provide an additional bonus in the short term.

I’ve entered a covered call position on each of these (described below).  If you’re also interested in this opportunity, my expectation is that the positions will be available for a few more days.

DAL covered call trades:

BUY 900 DAL @ $7.44 = $6,696 cost

SELL 9 SEP calls $7.00 strike @ $0.83 = $747 credit

Analysis: As long as DAL remains above $7.00 through expiration (September 16, 2011), we’ll net $351: We keep the $747 credit for selling the calls, but we’ll lose $396 because we’ll have to give up our shares at the $7.00 strike price.

Altogether, this represents a 5.25% return on a one month investment.

If DAL dips below $7.00 (which would represent a 6% drop) our yield would begin to decrease. The break even point is $6.60, 12% below our entry. Below $6.60 we begin to lose money on the position.

OIL covered call trades:

BUY 400 OIL @ $21.19 = $8,476 cost

SELL 4 SEP calls $21.00 strike @ $1.24 = $496 credit

Analysis: The numbers work out similarly to the DAL position. If OIL remains above $21, we’ll net 4.97%. The break even point is $19.94, which would require a 6% decline in the price of oil.

Because of the way options contracts work, we have to buy the stocks (or ETFs) in lots of 100. So I had to choose between a $6K position in OIL or an $8K position — that means I can’t be perfectly balanced between OIL and DAL. I chose to be slightly longer in OIL because I’m more confident in OIL going up over the next month.

OIL and DAL together with the market…

Daily performance of DAL and OIL is anti-correlated.

The chart at left shows how, over the short term (one month), DAL and OIL move in opposite directions. The expectation for these trades is that they’ll BOTH go up, but because they are anti-correlated, one will hedge the other if we see a significant drop in one or the other of these equities.

Market risk: This all has to be taken in the context of the market of course. Overall, we want to see a net gain, but in the shorter term we’ll be happy to beat the S&P 500. OIL and DAL are fairly conservative positions with regard to the S&P, so I’m hopeful we’ll at least beat the S&P.

How to hedge against market risk?

If you want to reduce risk further you can consider ways to hedge market risk. If you’re in a margin account the easiest method is to short SPY (an ETF representing the S&P 500). We’re trading in a long-only portfolio so shorting isn’t available. However, in a long-only portfolio you can hedge market risk by purchasing SH, an ETF that represents the daily returns of a short position on the S&P 500.

Sizing the position for this hedge is tricky because you’ll end up losing money if you take too large of a position and your long positions both go up — because the upside is limited on these trades.

In this case, I’m choosing not to hedge market risk. If you feel that you must, I’d recommend a position in SH equal to about 30% of the long side.

I’ll update this thread as we move forward to the September expiration date.

Update: How it came out:

On Friday September 16 DAL and OIL closed above our call strike prices ($8.40 for DAL and $22.30 for OIL).  So our positions liquidated at the strike prices and we kept the premium.

So we won on both deals. In 28 days we made 4.96% on DAL and 4.73% on OIL Net is $732.70 overall.

Disclosure: Tucker Balch is long OIL, DAL and SH.

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Posted in: strategy