Crude Calculations: Using Options to Bet on Oil
www.thestreet.com By Steven Smith Staff Reporter 03/04/2003 06:52 AM EST
Oil, oil everywhere: in the news, on people's minds, filling SUVs, heating homes, monopolizing the business section. And yet, so little profit to be had.
Not to sound like reality TV, but the current environment presents the ultimate challenge: Can anyone find a reasonable, defendable, potentially rewarding way to trade in today's environment, without risking the mother of all losses? Options, as always, will give you a fighting chance.
I know my compatriots on this site have done a great job mapping the current oil landscape. My condensed version is that the prospect of war with Iraq has put a $5 to $6 premium on crude prices.
"There is a lot of panic waiting for not necessarily the outcome, but the initiation of a set of events that will lead to a resolution," said Bill O'Grady, an energy analyst with A.G Edwards.
In the last six months, April crude oil futures have jumped 38.5% to nearly $40 a barrel, more than 17% higher than the June oil future price of $33.10.
But O'Grady is quick to point out that fundamentals, such as a cold winter, turmoil in Venezuela, rising natural gas prices and an overhang of uncertainty, will all lead to an inability to quickly replace lost reserves and increase production capacity. "I see a floor on oil prices somewhere above the $29-per-barrel range for the next 18 months," O'Grady concludes. He thinks that's where the equilibrium will be found as war fears dissipate and positive fundamentals underpin the market.
Unfulfilled Potential
Certainly the oil stocks and their proxies are, for whatever reason, acting poorly in the face of rising oil prices.
Exchange-traded offerings, such as Barclay's iShares' Global Energy Index Fund(IXC:NYSE - news - commentary - research - analysis) and the Merrill Holder Trust Oil Services(OIH:NYSE - news - commentary - research - analysis), have also lagged the market. The business fundamentals are beyond the scope of this article and therefore we will discuss oil futures and options as the purest means to position ourselves to profit from the future direction of oil prices.
That brings us back to the top. Conventional wisdom has it that oil prices will drop some 12% to 15%, or $5, once the U.S invades Iraq. So, that means we will be operating under the thesis that front month (as measured by the April futures) has an embedded war premium of about $5 over June. April options volatility is also running at about 50, or about 5 points higher than June. We assume both will narrow and the price of oil will stay above $30 during the next four months.
Let's see if we can take advantage of the price discrepancy in both the underlying oil price and their related options valuations.
The Trade
On Monday, Light Sweet Crude for delivery in April closed at $37.65 on the New York Mercantile Exchange. Based on settlement prices, one could sell the April $35 call for $3.25 and buy the April $37 call for $1.20 -- otherwise known as the bearish vertical call spread -- for a net credit of $2.05. The thesis is that, given recent events, the price of April oil won't go much above $37.05 by April expiration. The table below shows the risk/reward and break-even.
The risk/reward on this may seem great, but remember we are betting that prices will fall once war breaks out. And we are going to couple this position with a bullish June put spread. This is to incorporate the second half of our thesis: that oil prices should have a floor of around $29 over the next four months. It will also help offset an unexpected rise in price and thereby act as a hedge to our April position.
War-Oil Options
Position Value Net Credit/Debit Max Profit at Less Than $35 Break Even at $37.05 Max Loss at Greater Than $38.25 Sell 1 April $35 call $325 $0 ($205) ($325) Buy 1 April $37 call ($120) $0 $5 $0 Net $205 $205 $0 ($325) Source: TSC Research
June futures closed at $32.80. Sell one June $33 put for $3 and buy one June $30 put for $1.50 for a net credit of $1.50. Without going through all the math, the put position in isolation gives you a maximum profit of $150 per spread if the June futures close above $33. The maximum loss is $150, which is realized at or below $28.50.
But when the two positions are combined, that raises your break-even to $38.55 (thanks to the net credit on the put spread), and lowers the break-even in June to $26.45, thanks to the credit in the April call spread.
And the maximum overall profit increases to $355 should the April/June spread narrow $2 to the $33-$35 range.