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Crude Reality: Time To Think Longer-Term Options For Oil?

Crude Reality: Time To Think Longer-Term Options For Oil?

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.

Related Link: Are You Living To Trade Or Trading To Live?

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.

This piece was originally posted here by Greg Loehr on April 30, 2015.

Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return.

A rollover is not your only alternative when dealing with old retirement plans. Please click here for more information on rollover alternatives.

Futures and futures options trading is speculative, and is not suitable for all investors. Please read the "Risk Disclosure for Futures and Options" prior to trading futures products.

Market volatility, volume, and system availability may delay account access and trade executions.

Past performance of a security or strategy does not guarantee future results or success.

Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.

Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.

The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2015 TD Ameritrade IP Company, Inc. All rights reserved. Used with permission.

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