Buying Crude Oil Call Options to Profit from a Rise in Crude Oil Prices

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Contents

Buying Crude Oil Call Options to Profit from a Rise in Crude Oil Prices

If you are bullish on crude oil, you can profit from a rise in crude oil price by buying (going long) crude oil call options.

Example: Long Crude Oil Call Option

You observed that the near-month NYMEX Light Sweet Crude Oil futures contract is trading at the price of USD 40.30 per barrel. A NYMEX Crude Oil call option with the same expiration month and a nearby strike price of USD 40.00 is being priced at USD 2.6900/barrel. Since each underlying NYMEX Light Sweet Crude Oil futures contract represents 1000 barrels of crude oil, the premium you need to pay to own the call option is USD 2,690.

Assuming that by option expiration day, the price of the underlying crude oil futures has risen by 15% and is now trading at USD 46.34 per barrel. At this price, your call option is now in the money.

Gain from Call Option Exercise

By exercising your call option now, you get to assume a long position in the underlying crude oil futures at the strike price of USD 40.00. This means that you get to buy the underlying crude oil at only USD 40.00/barrel on delivery day.

To take profit, you enter an offsetting short futures position in one contract of the underlying crude oil futures at the market price of USD 46.35 per barrel, resulting in a gain of USD 6.3400/barrel. Since each NYMEX Light Sweet Crude Oil call option covers 1000 barrels of crude oil, gain from the long call position is USD 6,340. Deducting the initial premium of USD 2,690 you paid to buy the call option, your net profit from the long call strategy will come to USD 3,650.

Long Crude Oil Call Option Strategy
Gain from Option Exercise = (Market Price of Underlying Futures – Option Strike Price) x Contract Size
= (USD 46.34/barrel – USD 40.00/barrel) x 1000 barrel
= USD 6,340
Investment = Initial Premium Paid
= USD 2,690
Net Profit = Gain from Option Exercise – Investment
= USD 6,340 – USD 2,690
= USD 3,650
Return on Investment = 136%

Sell-to-Close Call Option

In practice, there is often no need to exercise the call option to realise the profit. You can close out the position by selling the call option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the crude oil option sale will be equal to it’s intrinsic value.

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Leverage using Calls, Not Margin Calls

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Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Buying Crude Oil Put Options to Profit from a Fall in Crude Oil Prices

If you are bearish on crude oil, you can profit from a fall in crude oil price by buying (going long) crude oil put options.

Example: Long Crude Oil Put Option

You observed that the near-month NYMEX Light Sweet Crude Oil futures contract is trading at the price of USD 40.30 per barrel. A NYMEX Crude Oil put option with the same expiration month and a nearby strike price of USD 40.00 is being priced at USD 2.6900/barrel. Since each underlying NYMEX Light Sweet Crude Oil futures contract represents 1,000 barrels of crude oil, the premium you need to pay to own the put option is USD 2,690.

Assuming that by option expiration day, the price of the underlying crude oil futures has fallen by 15% and is now trading at USD 34.25 per barrel. At this price, your put option is now in the money.

Gain from Put Option Exercise

By exercising your put option now, you get to assume a short position in the underlying crude oil futures at the strike price of USD 40.00. In other words, it also means that you get to sell 1,000 barrels of crude oil at USD 40.00/barrel on delivery day.

To take profit, you enter an offsetting long futures position in one contract of the underlying crude oil futures at the market price of USD 34.26 per barrel, resulting in a gain of USD 5.7500/barrel. Since each NYMEX Light Sweet Crude Oil put option covers 1,000 barrels of crude oil, gain from the long put position is USD 5,750. Deducting the initial premium of USD 2,690 you paid to purchase the put option, your net profit from the long put strategy will come to USD 3,060.

Long Crude Oil Put Option Strategy
Gain from Option Exercise = (Option Strike Price – Market Price of Underlying Futures) x Contract Size
= (USD 40.00/barrel – USD 34.25/barrel) x 1000 barrel
= USD 5,750
Investment = Initial Premium Paid
= USD 2,690
Net Profit = Gain from Option Exercise – Investment
= USD 5,750 – USD 2,690
= USD 3,060
Return on Investment = 114%

Sell-to-Close Put Option

In practice, there is often no need to exercise the put option to realise the profit. You can close out the position by selling the put option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the crude oil option sale will be equal to it’s intrinsic value.

Learn More About Crude Oil Futures & Options Trading

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

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Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

5 Steps to Making a Profit in Crude Oil Trading

Crude oil trading offers excellent opportunities to profit in nearly all market conditions due to its unique standing within the world’s economic and political systems. Also, energy sector volatility has risen sharply in recent years, ensuring strong trends that can produce consistent returns for short-term swing trades and long-term timing strategies.

Market participants often fail to take full advantage of crude oil fluctuations, either because they haven’t learned the unique characteristics of these markets or because they’re unaware of the hidden pitfalls that can eat into earnings. In addition, not all energy-focused financial instruments are created equally, with a subset of these securities more likely to produce positive results.

Key Takeaways

  • If you want to play the oil markets, this important commodity can provide a highly liquid asset class with which to trade several strategies.
  • First, decide if spot oil (and if so what grade), a derivative product like futures or options, or an exchange-trade product like an ETN or ETF are most appropriate for you.
  • Then, focus on the oil market fundamentals and what drives supply, demand, and price action, as well as technical indicators gleaned from charts.

How Can I Buy Oil As An Investment?

Here are five steps needed to make a consistent profit in the markets.

1. Learn What Moves Crude Oil

Crude oil moves through perceptions of supply and demand, affected by worldwide output, as well as global economic prosperity. Oversupply and shrinking demand encourage traders to sell crude oil markets to lower ground while rising demand and declining or flat production encourages traders to bid crude oil to higher ground.

Tight convergence between positive elements can produce powerful uptrends, like the surge of crude oil to $145.81 per barrel in July 2008, while tight convergence between negative elements can create equally powerful downtrends, like the August 2020 collapse to $37.75 per barrel  . Price action tends to build narrow trading ranges when crude oil reacts to mixed conditions, with sideways action often persisting for years at a time.

2. Understand the Crowd

Professional traders and hedgers dominate the energy futures markets, with industry players taking positions to offset physical exposure while hedge funds speculate on long- and short-term direction. Retail traders and investors exert less influence here than in more emotional markets, like precious metals or high beta growth stocks.

Retail’s influence rises when crude oil trends sharply, attracting capital from small players who are drawn into these markets by front-page headlines and table-pounding talking heads. The subsequent waves of greed and fear can intensify underlying trend momentum, contributing to historic climaxes and collapses that print exceptionally high volume. (For related reading, see: Financial Markets: When Fear and Greed Take Over.)

3. Choose Between Brent and WTI Crude Oil

Crude oil trades through two primary markets, West Texas Intermediate Crude and Brent Crude. WTI originates in the U.S. Permian Basin and other local sources while Brent comes from more than a dozen fields in the North Atlantic. These varieties contain different sulfur content and API gravity, with lower levels commonly called light sweet crude oil. Brent has become a better indicator of worldwide pricing in recent years, although WTI in 2020 was more heavily traded in the world futures markets (after two years of Brent volume leadership).

Pricing between these grades stayed within a narrow band for years, but that came to an end in 2020 when the two markets diverged sharply due to a rapidly changing supply versus demand environment. The rise of U.S. oil production, driven by shale and fracking technology, increased WTI output at the same time Brent drilling underwent a rapid decrease.

U.S. law dating back to the Arab oil embargo in the 1970s aggravated this division, prohibiting local oil companies from selling their inventory in overseas markets. This ban was removed in 2020. 

Many of CME Group’s New York Mercantile Exchange (NYMEX) futures contracts track the WTI benchmark, with the “CL” ticker attracting significant daily volume. The majority of futures traders can focus exclusively on this contract and its many derivatives. Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) offer equity access to crude oil, but their mathematical construction generates significant limitations due to contango and backwardation.

4. Read the Long-Term Chart

WTI crude oil rose after World War II, peaking in the upper $20s and entering a narrow band until the embargo in the 1970s triggered a parabolic rally to $120. It peaked late in the decade and began a torturous decline, dropping into the teens ahead of the new millennium. Crude oil entered a new and powerful uptrend in 1999, rising to an all-time high at $157.73 in June 2008. It then dropped into a massive trading range between that level and the upper $20s, settling around $55 at the end of 2020. As of Feb. 13, 2020, it closed at $51.52. 

5. Pick Your Venue

The NYMEX WTI Light Sweet Crude Oil futures contract (CL) trades in excess of 10 million contracts per month, offering superb liquidity. However, it has a relatively high risk due to the 1,000 barrel contract unit and .01 per barrel minimum price fluctuation.   There are dozens of other energy-based products offered through NYMEX, with the vast majority attracting professional speculators but few private traders or investors.

The U.S. Oil Fund offers the most popular way to play crude oil through equities, posting average daily volume in excess of 20-million shares. This security tracks WTI futures but is vulnerable to contango, due to discrepancies between front month and longer-dated contracts that reduce the size of price extensions.

Oil companies and sector funds offer diverse industry exposure, with production, exploration, and oil service operations presenting different trends and opportunities. While the majority of companies track general crude oil trends, they can diverge sharply for long periods. These counter-swings often occur when equity markets are trending sharply, with rallies or selloffs triggering cross-market correlation that promotes lockstep behavior between diverse sectors.

Some of the largest U.S. oil company funds and their average daily volume as of Feb. 14, 2020, are:

  • SPDR Energy Select Sector Fund: 14,959,493 
  • SPDR S&P Oil and Gas Exploration and Production ETF: 29,009,145 
  • VanEck Vectors Oil Services ETF: 9,882,904 
  • iShares U.S. Energy ETF: 552,719 
  • Vanguard Energy Index Fund ETF: 543,733 

Reserve currencies offer an excellent way to take long-term crude oil exposure, with the economies of many nations leveraged closely to their energy resources. U.S. dollar crosses with Columbian and Mexican pesos, under tickers USD/COP and USD/MXN, have been tracking crude oil for years, offering speculators highly liquid and easily scaled access to uptrends and downtrends. Bearish crude oil positions require buying these crosses while bullish positions require selling them short.

The Bottom Line

Trading in crude oil and energy markets requires exceptional skill sets to build consistent profits. Market players looking to trade crude oil futures and its numerous derivatives need to learn what moves the commodity, the nature of the prevailing crowd, the long-term price history, and physical variations between different grades. (For related reading, see: Introduction to Trading in Oil Futures.)

Oil Volatility and How to Profit From It

The recent volatility in oil prices presents an excellent opportunity for traders to make a profit if they are able to predict the right direction. Volatility is measured as the expected change in the price of an instrument in either direction. For example, if oil volatility is 15% and current oil prices are $100, it means that within the next year traders expect oil prices to change by 15% (either reach $85 or $115).

If the current volatility is more than the historical volatility, traders expect higher volatility in prices going forward. If the current volatility is lower than the long-term average, traders expect lower volatility in prices going forward. The CBOE’s (CBOE) OVX tracks the implied volatility of at-the-money strike prices for the U.S. Oil Fund Exchange-traded fund. The ETF tracks the movement of WTI Crude Oil (WTI) by purchasing NYMEX crude oil futures.

Buying and Selling Volatility

Traders can benefit from volatile oil prices by using derivative strategies. These mostly consist of simultaneously buying and selling options and taking positions in futures contracts on the exchanges offering crude oil derivative products. A strategy employed by traders to buy volatility, or profit from an increase in volatility, is called a “long straddle.” It consists of buying a call and a put option at the same strike price. The strategy becomes profitable if there is a sizeable move in either the upward or downward direction.

For example, if oil is trading at US$75 and the at-the-money strike price call option is trading at $3, and the at-the-money strike price put option is trading at $4, the strategy becomes profitable for more than a $7 movement in the price of oil. So, if the oil price rises beyond $82 or drops beyond $68 (excluding brokerage charges), the strategy is profitable. It is also possible to implement this strategy using out-of-the-money options, also called a “long strangle,” which reduces the upfront premium costs but would require a larger movement in the share price for the strategy to be profitable. The maximum profit is theoretically unlimited on the upside and the maximum loss is limited to $7. (For related insight, read more about how to buy oil options.)

The strategy to sell volatility, or to benefit from decreasing or stable volatility, is called a “short straddle.” It consists of selling a call and a put option at the same strike price. The strategy becomes profitable if the price is range-bound. For example, if oil is trading at US$75 and the at-the-money strike price call option is trading at $3, and the at-the-money strike price put option is trading at $4, the strategy becomes profitable if there is no more than a $7 movement in the price of oil. So, if the oil price rises to $82 or drops to $68 (excluding brokerage charges), the strategy is profitable. It is also possible to implement this strategy using out-of-the-money options, called a “short strangle,” which decreases the maximum attainable profit but increases the range within which the strategy is profitable. The maximum profit is limited to $7, while the maximum loss is theoretically unlimited on the upside. (For related insight, read about how low oil prices can go.)

The above strategies are bidirectional; they are independent of the direction of the move. If the trader has a view on the price of oil, the trader can implement spreads that give the trader the chance to profit, and at the same time, limit risk.

Bullish and Bearish Strategies

A popular bearish strategy is the bear-call spread, which consists of selling an out-of-the-money call and buying an even further out-of-the-money call. The difference between the premiums is the net credit amount and is the maximum profit for the strategy. The maximum loss is the difference between the strike prices and the net credit amount. For example, if oil is trading at $75, and the $80 and $85 strike-price call options are trading at $2.5 and $0.5, respectively, the maximum profit is the net credit, or $2 ($2.5 – $0.5), and the maximum loss is $3 ($5 – $2). This strategy can also be implemented using put options by selling an out-of-the-money put and buying an even further out-of-the-money put.

A similar bullish strategy is the bull-call spread, which consists of buying an out-of-the-money call and selling an even further out-of-the-money call. The difference between the premiums is the net debit amount and is the maximum loss for the strategy. The maximum profit is the difference between the difference between the strike prices and the net debit amount. For example, if oil is trading at $75, and the $80 and $85 strike-price call options are trading at $2.5 and $0.5, respectively, the maximum loss is the net debit, or $2 ($2.5 – $0.5), and the maximum profit is $3 ($5 – $2). This strategy can also be implemented using put options by buying an out-of-the-money put and selling an even further out-of-the-money put.

It is also possible to take unidirectional or complex spread positions using futures. The only disadvantage is that the margin required for entering into a futures position would be higher than it would be for entering into an options position.

The Bottom Line

Traders can profit from volatility in oil prices just like they can profit from swings in stock prices. This profit is achieved by using derivatives to gain leveraged exposure to the underlying asset without currently owning or needing to own the asset itself.

Buying Crude Oil Call Options to Profit from a Rise in Crude Oil Prices

In a recent Bloomberg article, “In a Risky World, Oil Traders Bet on $100 a Barrel” the author explored how, “Some oil traders have started to gear up for a possible price surge as political risks escalate”. If you follow Bloomberg, Reuters, etc. oil reporting, you’ve likely seen one of these articles before as they tend to appear every few months, often using activity in deep out-of-the-money (OTM) options trades as confirmation of a speculative opinion.

Let’s consider what a trader receives when buying call options to see why he or she might purchase $100 calls on December Brent crude oil, which is currently trading around $70/bbl, and if this tells us anything about the trader’s opinion on the future direction of crude oil prices.

When buying a deep OTM call, the trader establishes a position that gains value when either/both the price of the underlying rises and/or volatility rises. The position loses value with the passage of time. The total risk is limited to premium paid. A trader might want this exposure for a variety of reasons. A few examples:

  1. The trader is in fact making a speculative call on rising prices, but not necessarily $90, $100, or $110 (the strikes referenced in the article). Oil prices don’t have to reach $90-$110 for the position to make money. A trader might judge the risk/reward from a deep OTM option with minimal premium to be superior to either near the money options or long fixed-price positions.
  2. The trader is buying volatility, expecting to profit when/if volatility rises, even if prices don’t rise.
  3. The trader might be optimizing or balancing his portfolio. The trader may be using these long options to address exposure to rising prices or volatility caused by an existing position. The trader may be short the underlying, for example, or hedging some other risk embedded in his or her book that would be reduced by a long call position.
  4. The trader may have closed a profitable long position, then used some of the profits to buy OTM calls. He or she could be playing with house money, so to speak.
  5. The trader may have executed an options combination or spread such as a call spread, collar, or three-way, which may not have included a 1:1 ratio of options contracts or may have executed a combination of options with different expiration dates.

In each of these examples, the call option buyer wants the exposure provided by buying a call option, but none of them are necessarily dependent on the expectation of $100 oil. The trader’s success (profit/loss) is dependent on the options sensitivity to the price of the underlying crude oil future or swap, time, and volatility. An option’s sensitivity to these variables can be calculated using the Greeks, which are summarized in the table below. Assume December Brent is trading at $70/bbl, a $100 call that expires in December has a premium of$0.10, and each change is demonstrated in isolation (“all else being equal”).

As these examples indicate, a trader who is long $100 calls has a lot more to consider than whether the price of Brent will rise to $100 in the next 6 months. An options trader can be correct on market direction, but still lose money because of how volatility and time affect the position. The $100 call is more sensitive to changes in time and volatility than price, so a pure bet on price is an unlikely reason for the spike in volume over the ten-day period the article considers. It seems unlikely (though not impossible) that oil will rebound to $100 between now and December; even less likely that traders are looking at $100/bbl Brent as the foundation of their primary investment thesis.

That being said, there is valuable information to be gleaned from the activity in the options market. At the moment, at least from the perspective of an oil consumer, options appear to be a better, conservative means of establishing a hedge, with a better risk/reward than a pure fixed price hedge such as futures or swaps. Furthermore, call options are currently providing a better value than put options which are similarly or equally OTM, which the author does note at the end of the article. In summary, depending on the risk you need to offset, it’s possible that deep OTM calls could indeed be a valuable component of a crude oil hedging program but as is usually the case, the devil is in the details.

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