Did You Make 175% Trading BP?

| July 27, 2010

A few weeks ago, I was sitting at my desk watching the stock ticker on CNBC.  I’ve spent way too much time over the years watching stock symbols and prices scroll across the screen.  But here I was again, doing the same thing I’ve done for most of my adult life.

Except this time, I was bothered by a price ticking by…

It was BP.  And it was trading down around $27.  Yet another round of negative press was pressuring prices.

We all know about the big oil spill in the Gulf of Mexico.  The company’s been taking a beating in mainstream media over the disaster.

Look, I can’t say I’m a big fan of BP.  Quite the opposite in fact.  I’m appalled by the environmental disaster the company is causing by (likely) being negligent.  I’d like nothing more than to short the heck out of the stock and watch it plummet.

But if I’ve learned one thing about trading it’s this:  don’t trade on emotion.

Like it or not, the financial markets aren’t about fairness.  The reality is what should happen is often very different than what does happen.  Your goal as a trader shouldn’t be about justice.  It should be about profit.

And profit was exactly what I had in mind that day…

You see, as I watched BP tick down, I decided it was ridiculously cheap.

Hey you never know.  BP may eventually go to zero.  I could be dead wrong.  Public backlash may become even more severe than it already is. Some news item could start a selling frenzy as investors look for less controversial companies to own.

But at least in the short-term, I felt the share price had only one way to go… up.

I filtered out the emotion-sparking headlines.  Instead, I looked at the fundamentals.  The company has huge oil reserves.  It’s also sitting on a ton of cash.  What’s more, it has the ability to sell off assets to raise even more cash if necessary.

But what really stood out to me was the valuation.  At $27 a share, the market was implying BP wouldn’t be able to plug the oil leak… for the rest of the year.

Literally.

The leak would have to spew oil into the Gulf of Mexico for the rest of the year to justify BP’s market cap.

Even more, BP’s price assumed the company is 100% liable for the damages.  It doesn’t even take into account the role of Anadarko (APC), a 35% owner of the leaking well, or Transocean (RIG) who made the faulty equipment.

So it came down to this…

BP had to find a way to plug the leak in the near future.  If it happened, I decided the stock price would rebound in a big way.

After looking at the facts, it was clear.  This opportunity was too good to pass up.

You see, BP still had several options for stopping the leak.  A relief well is being drilled to block the flow of oil at a different point.  It’s supposed to be completed by late August.  Meanwhile, the company is still working on new ways to cap the well.

It seemed to me the leak would very likely get plugged by the end of August…

So I put my thesis into play by purchasing August call spreads.

For those of you who don’t know, a call spread is when you buy a call option and simultaneously sell a higher call in the same expiration month. Basically, you make money when the underlying stock price goes above your lower (long) strike.  But, your upside is capped once the stock goes above your higher (short) strike.

You only lose money if the stock closes below your lower strike.

The reason why you’d do a call spread is to reduce your cost.  When you sell a call, the proceeds are used to pay for the price of the more expensive call.  Your profit potential can still be huge.

For example, take a look at my BP call spread…

When BP stock was trading around $27, I decided to put on the August 35-40 call spread.  I purchased the August 35 call for $76 and simultaneously sold the August 40 call for $19.  So, each spread cost me $57 total.

By using a call spread, I reduced my costs by 25%.  But, I could make close to $450 per spread if the stock went to $40 by August expiration.

That’s over an 800% return!

In this case, I actually set my profit goals somewhat lower.  I was looking to get in and out quickly.  So, I settled on a target return of just over 100%.

Almost immediately, positive news started hitting the wire…

BP was making progress on drilling its relief well.  They also started billing Anardarko for part of the cleanup cost.  In addition, they planned to sell $7 billion of assets to raise cash.

The stock started to climb.

On June 25th, the day I made the trade, BP was trading around $27.  On July 12th, buoyed by a torrent of good news, BP cracked the $35 mark.

In just three weeks, the market agreed with me.  BP was severely undervalued.  The stock jumped higher and I was making money!

I closed the trade by selling my call spread for $157.  Exactly $100 higher than what I paid.

I made 175% in three weeks!

All because I didn’t let my emotions get a hold of me.

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Category: Commodities

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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