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6/15/05
NOTHING FOCUSES THE MIND LIKE THE GALLOWS
June 15, 2005
Another week, another $2 billion settlement! It seems like only yesterday that Citigroup settled a class action lawsuit brought by the University of California that accused the investment bank of aiding Enron and helping to defraud millions of investors around the world.
The reason it seemed like only yesterday was that, yes, it was just yesterday! Well, at the close of business Tuesday (last night), JP Morgan reached an agreement to settle the Enron class-action lawsuit brought on behalf of Enron security-holders for a fatter figure -- $2.2 billion!
As they say, nothing focuses the mind like the gallows, and when Citi rolled over and coughed up $2 billion to make most of their liabilities go away, it would have been ill-advised for JP Morgan not to plead out as well.
The next shoes to drop in this sad chapter in U.S. business history will be the well-worn oxfords of Merrill Lynch and Credit Suisse First Boston, which are the last of the accused left to settle. When they do, look for the allocation pool to top the record $6 billion-plus of the WorldCom debacle!
I know most of you are very familiar with the events that took place at Enron, but I have highlighted some of the lowlights below, as this story is indeed stranger than fiction!
The Enron scandal by the numbers:
CATCHING THE CHANGEWAVE -- TIME TO ADD A DOSE OF ENERGY
Like Toby Smith with his Canadian Royalty Trust plays, I LOVE, LOVE, LOVE the energy patch! The toughest thing about investing here, though, is finding a value among the hundreds of great companies, most of which are trading at 90% of my projected valuations.
Since we rung the register in Valero Energy (VLO) last week (and keep in mind that when we first published that one on March 7, it ran so fast that we had to move up our strikes by $5 just to get in!), we've got room in the portfolio for another energy play. And this week's best value is Edge Petroleum Corp. (EPEX).
Edge Petroleum is engaged in the exploration, development, acquisition and production of oil and natural gas in the U.S. It primarily conducts its operations in southern Texas, Louisiana and southeastern New Mexico.
The company was founded in 1983 and is based in Houston. I show the five-year total return performance of 20.2%, which is very impressive and very steady.
At $15 a share, Edge Petroleum is trading for just above 12 times earnings. Its first-quarter net income was $4.7 million -- a 44% increase over the year before. The 52-week range is $12.44 to $19.81, a high it hit back in July last year when crude was considerably lower!
To get some momentum out of this energy play, I recommend buying the EPEX Sept 15 Calls (EBQIC) and selling a like number of the EPEX Sept 17.50 Calls (EBQIW) for a net debit of 90 cents.
Prices that work for you do-it-yourselfers are paying $1.60 for the Sept 15 Calls and selling the Sept 17.50 Calls for 70 cents.
To make a limited-risk investment in Edge Petroleum, I recommend buying the EPEX Sept 15-17.50 bull-call spread for a net debit of 90 cents.
TRADE DETAILS
All information is based on prices as of 11:45 a.m. Eastern on Wednesday, June 15, 2005.
* NOTE: This example follows the most current prices available to us at the time of publication. You can still enter the trade for up to 95 cents for the EPEX Sept 15-17.50 bull-call spread through Wednesday, June 22, as long as EPEX shares trade for $14.75 or higher.
Here is the information you need to know to buy our Edge Petroleum bull-call spread for profits:
Underlying Stock: Edge Petroleum (EPEX)
Current Stock Price: $15.65
Trade Type: Bull-call spread
Options to Trade: The specific trades to make are in the table below...
| Action | Quantity | Option | Strike Price | Ticker | Investment | |
| Buy | 1 | EPEX Sept 15 Call | $15 | EBQIC | -$1.60 | |
| Sell | 1 | EPEX Sept 17.50 Call | $17.50 | EBQIW | +$0.70 | |
| Net Cost | -$0.90 |
*A minus sign (-) indicates an amount you pay; a plus sign (+) indicates an amount you receive.
Making The Trade:
If you give this trade to your broker at a net debit of 90 cents, then it doesn't matter which prices your broker pays for the individual parts of the bull-call spread. Thus, our net debit would be 90 cents, or $90 for each spread. (For those of you who are do-it-yourselfers and are making the trade online, an order to buy the EPEX Sept 15 Calls (EBQIC) for $1.60 while simultaneously selling the EPEX Sept 17.50 Calls (EBQIW) for 70 cents puts you in the trade with a net debit of 90 cents.)
Our loss is limited to the 90 cents that we are paying for the spread. If, on the other hand, Edge Petroleum rises above $17.50 on September expiration, then we make $1.60 on our 90-cent investment!
SUMMARY
With Edge Petroleum trading for $15.65, a 1,000-share position would tie up $15,650. However, with our trade you'll be able to put just $900 at risk and have a potential gain of $1,600 if Edge Petroleum rises to $17.50 or higher.
Here’s why:
* Our net investment on that bull-call spread is the difference between what we paid for the EPEX Sept 15 Calls ($1.60) and our credit on the EPEX Sept 17.50 Calls (70 cents), or a net debit of $90 per contract.
* With EPEX trading at $15.65, a 1,000-share position would cost us $15,650.
* Instead, if we buy 10 of the EPEX Sept 15 Calls (EBQIC) for $1.60 ($1.60 each times 100 shares = $160 per contract), or $1,600 and ...
* Against that purchase, we sell 10 of the EPEX Sept 17.50 Calls (EBQIW) for 70 cents (70 cents each times 100 shares = $70 per contract), or $700.
* Thus, on a 10-contract spread we have only $900 invested, so that's all we can lose!
* If you follow these guidelines, this means your broker can pay no more than 90 cents and you avoid the risk of "legging the spread" -- that is, buying one side and waiting to sell the other.
* NOTE: Keep in mind that nobody knows your risk tolerance or financial situation better than you. A single bull-call spread in this example will cost you $90 plus commissions. As long as you maintain the ratio of one contract purchased against one contract sold, you can ramp up this strategy as big, or make it as small, as you’d like.
* Remember, you can pay up to 95 cents for this spread trade through Wednesday, June 22, as long as EPEX shares trade for $14.75 or higher.
TRADE PROFITABILITY ANALYSIS
To illustrate how and where you will make money on this trade, I have included a payoff diagram at the start of this section. You can use this chart to follow along with my explanation below:
If you look at the shaded areas as they compare to the horizontal axis that tracks the price of EPEX shares, you can see that the trade becomes profitable (green area) when the underlying stock crosses the $15.90 level. Likewise, while the stock is under $15.90, we are below the axis (red area) where the bull-call spread registers a profit.
As with any 1-to-1 bull-call spread, our risk is limited to what we pay for the spread -- in this case, 90 cents.
Breakeven: $15.90
The breakeven is $15.90 because, as in any bull-call spread, the breakeven is determined by adding the net cost of the spread (90 cents in this case) to the strike price of the call you are buying. Again, because we paid $1.60 for the EPEX Sept 15 Calls and took in 70 cents for the sale of the EPEX Sept 17.50 Calls, our net out-of-pocket is 90 cents. You add that net to the strike price we’ve purchased ($15) and you get your breakeven of $15.90.
Max Profit: $160 per spread ($1.60 x 100 shares)
The max profit is determined by taking the difference between the two strikes of the bull-call spread, which in this case is $2.50 ($17.50 – $15 = $2.50) and subtracting the amount we paid for the spread (90 cents) and is therefore $1.60. Thus, if EPEX is $17.50 or higher on expiration, then the spread will achieve that $2.50 max and, because we paid 90 cents for the spread, that would leave us with a $1.60 profit, or 177.8%. On a 10-contract spread, that would translate to a profit of $1,600!
*This analysis does NOT include the cost of commissions while executing your trades.
