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Oil Rout Over, Options Traders? Low Doesn’t Mean “Cheap”

January 29, 2015
Oil Rout Over, Options Traders? Low Doesn’t Mean “Cheap”

Everyone loves a bargain.

But what do traders love even more? Calling a market's top or bottom. It's tempting to call a bottom in crude oil, given the recent rout that’s sent prices reeling to six-year lows.

The oil market showed signs of stabilizing this month, with futures prices posting a higher close week-over-week. We’ve heard some suggestions that—maybe—prices have found a floor.

Careful ...

Remember, a higher weekly close doesn’t necessarily mean oil prices are heading back up anytime soon, or are even finished dropping (benchmark U.S. crude futures fell under $44 a barrel in morning trading January 29, extending a slide to six-year lows). Here’s another important distinction: just because the price of something is lower than it was before, that doesn’t mean it’s cheap.

Yet, in case oil is indeed establishing a bottom, it’s possible to stick your neck out a bit through the options markets without having to worry too much about it getting cut off. And even if you’re not on target, you can still potentially generate income with certain options positions. Here’s how.

Option premiums on oil-linked indexes are at multi-year highs, even as prices for the underlying stocks and exchange-traded funds are at multi-year lows. Such high option premiums present potential ways to play a bounce in oil prices, a drop in options volatility, or both.

For instance, selling out-of-the-money put options (depending on the time until expiration and strike price) might be able to withstand another 20% dip in oil before dropping below the breakeven price of the option trade.

FIGURE 1: LOSING ENERGY. The SIG Oil Exploration & Production Index (ticker EPX), which tracks energy producer shares, fell as much as 46% from a June peak as crude prices sank. Source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only.

By selling puts at these high levels, you can create a position that can potentially profit if oil stabilizes or goes higher. Plus, it’s still possible to profit even if oil continues its slide. That can make for a pretty safe trade (though keep in mind that if oil drops below the strike price of the put by more than the amount of the premium collected, the position turns into a loser).

If and when oil prices actually start to form a base (meaning, more than just one week of higher prices), option volatility will tumble and the time value on the put options you sold will decline, thus generating potential gains.

If selling put options exposes you to too much risk, consider selling a put spread instead of just a straight put. By buying a put that’s a little further out-of-the-money than the option you sell, you’re selling a put spread, which limits the risk of the trade but still creates the chance to make money with oil going higher, flattening out, or even moving somewhat lower (the risks of such a position include an obligation to buy the underlying stock at the strike price, as well as a continued decline in oil prices below your strike).

Calculate the breakeven price of your trade by subtracting the premium you collected from the strike price (if oil is below that point at expiration, the trade begins to lose; above that price, and you're seeing gains). Then, look at the chart, and decide whether you’re okay with what you see.

It’s important to remember that oil and other commodity-related investments are not suitable for all investors. These markets can be extremely volatile and subject to surprise global or macro events, such as wars, weather, economic sanctions, and import controls.

Moreover, just stay alert and be ready to act. These high premiums are not going to last. Oil prices will recover at some point, so think about how you might queue up your options positions to prepare, and possibly capitalize.

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