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

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Contents

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.

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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 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.

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. ]

What are Binary Options and How to Trade Them?

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. ]

Hedging with WTI Crude Oil Weekly Options

The Crude Oil futures and options markets are the most liquid and actively traded global commodities contracts in the world. With Weekly Options on WTI Crude Oil Futures expiring on Friday each week, CME Group provides market participants with a flexible tool to fine tune their crude oil market exposure. The addition of Weekly Options to a trader’s hedging strategy offers a low-cost tool to mitigate risk associated physical or financial positions.

Market moving events such as OPEC announcements, EIA inventory data, and geopolitical events can significantly impact volatility in crude oil markets. Weekly Options give traders greater flexibility to manage volatility arising from these events, along with the added features of shorter expirations and lower premiums.

Key features

  • Expire every Friday and exercise into the active futures contract
  • Automatic exercise with no contrary instructions
  • Flexibility to manage short-term volatility and risk
  • Precision timing to target specific market movements or events like OPEC meetings
  • More flexible hedging at a lower premium
  • Figure 1. WTI Weekly Options Performance

    Crude Oil Weekly Options – Storage Applications

    Crude oil options trading is applicable to market participants with exposure to crude oil price volatility. Since crude oil prices are settled to a new price each day, using a specific series of days is useful to fit a given pricing window for both buyers and sellers. Scenarios in which traders and producers require short-term storage can provide opportunities for utilizing Weekly Options strategies. The forward term structure in crude oil is largely influenced by supply/demand, storage costs, and production estimates. The shape of the forward curve has important implications for inventory management. If the market is backwardated (Figure 2), then the current value of inventory is greater than the deferred future price. In this environment, producers and traders are unlikely to store product for long-periods of time and may have a need to hedge short-term storage exposure over the course of 1-4 weeks. Depending on a trader’s short-term storage strategy, they will need to reduce intramonth price exposure in the case of a market moving event. In Example 1 we will look at utilizing Weekly Crude Oil options to hedge physical price exposure during an adverse global event.

    Figure 2. WTI Crude Oil Futures Term Structure (1/6/2020)

    Crude Oil Weekly Option Example 1: Coronavirus Outbreak

    A Crude Oil trader purchases a cargo and intends to store it until a buyer is procured. The trader wishes to hedge his price exposure over the coming week as he finds a buyer. For hedging purposes, the trader implements a collar strategy which includes purchasing an at-the-money Weekly put option and selling an out-of-the-money Weekly call option with the same expiry. This strategy allows the trader to hedge downside risk while reducing the cost of the strategy by selling the call. The trader will have limited upside set at the strike price of the call but has partially offset the cost of the hedge. Additionally, the trader’s expiration timeline is precise and tailored to his specific short-term needs.

    Date: 1/6/2020

    WTI Futures Feb20 Price: $62.00/bbl

    Physical Position: 100k bbls

    Collar Strategy:

    Buy 100 Weekly Puts @$62.00 for $0.40 premium

    Sell 100 Weekly Calls @$65.00 for $0.30 premium

    On Monday 1/6/2020 the trader initiates a collar using Weekly Options that expire on Friday 1/10/2020. At expiry, the underlying WTI Futures Feb20 price drops and settles at $59.00/bbl following World Health Organization reports that the coronavirus has broken out in Wuhan, China. The trader’s physical position of 100,000 bbls realizes a $300,000 loss in value while in storage. However, because the trader has used Weekly Options to construct a collar hedge, he has offset the loss with a $290,000 gain generated through his options position ($300,000 gross profit – $10,000 cost to implement the strategy).

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    Figure 3. Collar Hedge Using Weekly Options

    Crude Oil Weekly Options – Downstream Applications

    Crude Oil Weekly Option Example 2: Refinery Risk Management

    A refiner has committed to buy 100,000 bbls of crude oil off the local pipeline in two weeks. The barrels will price the week of delivery and the refiner has concerns that markets may rally ahead of the pricing week. As a result, she purchases an at-the-money Weekly call option that is available for the exact week of the delivery at a cost well below the monthly option that expires the following week. She is comfortable locking in a price of $57.00/bbl using this option strategy. On the Wednesday before the pricing week, the market experiences a sizable and unexpected draw in crude oil inventories reported by the EIA, pushing the price of WTI up 4%. The refiner’s P/L using a Weekly call option can be seen below.

    Date: 12/2/2020

    Jan20 WTI Futures Price: $56.00/bbl

    Committed Physical Exposure: 100k bbls

    Long Call Hedge Strategy:

    Buy 100 Weekly Calls @ $56.00 for $1.00 premium

    By Friday 12/13/2020, Jan20 WTI Futures price rises and settles at $60.00/bbl following the previous week’s bullish EIA crude oil inventory report. The refiner purchases 100,000 physical bbls @ $60.00/bbl for $6,000,000 ($400,000 more than expected on 12/2/2020 when WTI Futures were $56.00). Profit from the Weekly call option hedge at expiry is $300,000 ($400,000 profit – $100,000 premium), leading to a reduced net payment of $5,700,000 or $57.00/bbl. The refiner leveraged the time and cost benefits associated with the Weekly call option to effectively hedge her supply cost against an unexpected move higher in futures prices

    Figure 4. Call Hedge Using Weekly Options

    Crude Oil Weekly Options – Upstream Applications

    Crude Oil Weekly Option Example 3: Producer Hedge

    A producer is required to hedge 70% of his supply on a monthly basis and is hedging his August 2020 production using WTI Futures. In the last week of July, the producer starts to see higher than expected yields in his wells and projects an increase in volume, leading to an underhedged position come August. The producer decides to utilize short-dated Weekly put options to provide some price certainty around the expected increase in volume and retain his 70% hedging covenant while he finds a buyer. To hedge his current expected production of 1,000,000 bbls and meet the 70% hedging requirement, the producer sells 700 Sep19 WTI Futures contracts (700,000 bbls). Late in July, well production is projected at 1,200,000 bbls, leaving 140,000 bbls unhedged (70% x 200,000 bbls). The producer is worried about the impact of certain geopolitical and economic announcements set for the week of July 29, 2020 and implements a Weekly bear put spread strategy that expires August 9, 2020 to hedge downside price risk. The bear put spread includes selling a lower strike put option and buying a higher strike put option with the same expiry in order to hedge against bearish market expectations. By purchasing a put spread instead of an outright put, the producer reduces the cost of the options hedge.

    Date: 7/29/2020

    Sep19 WTI Futures Price: $56.00/bbl

    Expected Physical Exposure: 140k bbls

    Bear Put Spread Strategy:

    Sell 140 Weekly Puts @ $53.00 for $0.20 premium

    Buy 140 Weekly Puts @ $56.00 for $0.70 premium

    From 7/29/2020 to 8/9/2020, Sep19 WTI Futures fall approximately 6% to $53.00/bbl due to additional U.S. tariffs on Chinese goods and bearish remarks from the Fed Chairman regarding the likelihood of future rate cuts. 70% of the producer’s additional well supply loses $420,000 in value after the two-week period but is offset by a $350,000 gain from the option strategy ($420,000 profit – $70,000 premium). The producer is now able to sell the additional 140,000 bbls at a net price of $55.50/bbl.

    The producer can replicate this strategy each week throughout the month to maintain his 70% mandate.

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