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Crude Reality: Time to Think Longer-Term Options for Oil?

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April 30, 2015
crude oil options

If you’ve been an owner of crude oil contracts for a while now, this sideways range between $42 and $55 since the start of the year has got to be welcome relief. At least the bleeding has stopped. If oil hasn’t been in your portfolio, you may be starting to wonder: is this the start of a bottom in oil prices?

You’re faced with an age-old conundrum, as old as fossil fuels themselves. Do you jump in now and risk getting run over if the landslide in oil prices continues? Or do you wait, and potentially miss out if prices rebound?

One way to participate in oil is with options. In fact, there’s a multitude of ways to put options to work. Here are a few examples to examine.

For traders looking to start a bullish position, buying in-the-money (ITM) calls on an option with an underlying that's based on oil, such as an exchange-traded fund (ETF), is one strategy to look at. For example, call options that have about an 80 delta mean you’ll have something that gives you 80% of the price movement in the underlying crude contract, but at a fraction of the cost of actually buying the underlying shares. Of course, that reduction in capital commitment has a down side, as it's accompanied by an increase in risk. Fees and commissions associated with options will apply.

If oil makes the rebound you’re looking for, then these options will go even further ITM, increasing the delta to the point where your call option moves one-for-one with the dollar move of oil. And if oil continues lower, your total downside risk is limited to the cost of the option, plus transaction costs. Of course, if the options expire worthless, the entire purchase price plus transaction costs would be lost.

Consider the Risks

One thing to keep in mind is that while your option risk is limited to its purchase price and transaction costs, there’s a situation where this loss could be greater than if you had put your money into the underlying itself.

Let’s say a fictional oil ETF trades at $20 and the ITM 18 strike call trades for $3. In this case, if you buy the call and the ETF drops to $18 (the strike of your call) at expiration, the option loses $3, which is 100% of its value, while the ETF only loses $2, or 10% of it value. Just something to be aware of.

Stackable Strategy?

Traders with longer-term bullish views might find that short-term option strategies can play a key part as well, essentially toward the same goal. One such trade could be a cash-secured short put. Here, the trader opens a position by selling a put option. This trade carries the obligation to buy the underlying if assigned, so the trader has to be comfortable buying shares at the strike price, and must deposit enough cash up front to cover the share purchase if necessary. Hence the name “cash-secured.”

One of two things will happen. First, if the option expires worthless at expiration, the trader keeps the premium from the sale, minus transaction costs. This happens if the underlying is above the strike price. Or, second, the trader could get assigned on the short option and buy the underlying at the strike price, in addition to keeping the premium, less transaction costs and assignment fees.

One downside to this—in addition to the potential risk of buying the underlying—is having the underlying surge in price. If that happens, the trader keeps the option premium, but misses the big move that they would've participated in had they purchased outright. Instead, they've committed themselves to purchase only if the price falls and a put option is assigned.

Options can be considered as an addition to approved accounts when you're ready for this level of trading. With either strategy, longer-term oil bulls have more "options" than just trying to pick the bottom.

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