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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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. ]

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  • Binomo
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    Trustful Broker. Recommended Only For Experienced Traders!

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. ]

Buying (Going Long) Crude Oil Futures 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 taking up a long position in the crude oil futures market. You can do so by buying (going long) one or more crude oil futures contracts at a futures exchange.

Example: Long Crude Oil Futures Trade

You decide to go long one near-month NYMEX Brent Crude Oil Futures contract at the price of USD 44.20 per barrel. Since each NYMEX Brent Crude Oil Futures contract represents 1000 barrels of crude oil, the value of the futures contract is USD 44,200. However, instead of paying the full value of the contract, you will only be required to deposit an initial margin of USD 12,825 to open the long futures position.

Assuming that a week later, the price of crude oil rises and correspondingly, the price of crude oil futures jumps to USD 48.62 per barrel. Each contract is now worth USD 48,620. So by selling your futures contract now, you can exit your long position in crude oil futures with a profit of USD 4,420.

Long Crude Oil Futures Strategy: Buy LOW, Sell HIGH
BUY 1000 barrels of crude oil at USD 44.20/barrel USD 44,200
SELL 1000 barrels of crude oil at USD 48.62/barrel USD 48,620
Profit USD 4,420
Investment (Initial Margin) USD 12,825
Return on Investment 34.46%

Margin Requirements & Leverage

In the examples shown above, although crude oil prices have moved by only 10%, the ROI generated is 34.46%. This leverage is made possible by the relatively low margin (approximately 29.02%) required to control a large amount of crude oil represented by each contract.

Leverage is a double edged weapon. The above examples only depict positive scenarios whereby the market is favorable towards you. If the market turn against you, you will be required to top up your account to meet the margin requirements in order for your futures position to remain open.

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. ]

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Crude Oil Futures Trading 101 – What Are They and Should You Invest in Them?

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With the price of oil skyrocketing (the price recently increased by 14% in a single week), you may be wondering if now is the right time to invest in this commodity.

There are plenty of ways to get in on the oil industry. For example, you can buy stocks of oil and drilling companies. But one of the most profitable – and riskiest – investments you can make is in oil futures.

In this article, we’ll look at what oil futures are, and then discuss the pros and cons of investing in them. You can then decide if they’re a good addition to your investment portfolio.

What Are Oil Futures?

Oil futures are derivative securities that give the holder the right to purchase oil at a specified price (similar to how stock options work). If you exercise your future by the settlement date, you can purchase oil (crude oil futures trade in units of 1,000 barrels) at the price stated in the futures contract.

If the price of oil looks like it is going to continue to increase, you can also hold the future while it appreciates in value and sell it at a later date to an investor who does intend to exercise it.

Advantages of Investing in Oil Futures

Oil futures can make great investments and are probably one of the most actively traded derivatives on the market. Some of the benefits of investing in oil futures include:

  1. Ability to make substantial profits. Oil futures can be extremely lucrative investments. Some investors have been able to make tens of thousands of dollars with a single trade, while investing much less than would be necessary in the stock market. The price of oil can change substantially in a short period of time, so futures investors can see a sudden appreciation in their investment. In periods when the price of oil skyrockets, everyone would love to be able to purchase it at a lower price. Anyone who holds a future that allows them to do so is going to be in a good position.
  2. Liquidity. Oil futures are one of the most liquid investments because of the high volume that is traded every day. In fact, they are the most actively traded future on the market and hence the most liquid.
  3. Leverage. You can purchase oil futures on margin (in other words, you can borrow money to purchase them). The margin requirements are set by the exchanges and for oil they are often as low as 5% of the value of the investment. That means you could buy $100,000 worth of oil futures for only $5,000. This can also be very dangerous, but it is nice to at least have options.
  4. Limited supply. Oil is an irreplaceable resource. The fact that there is a finite supply is depressing for most people, but it can work to the advantage of investors who choose to invest in its futures. Other commodities futures such as corn and livestock can be replaced and their prices can be stabilized. However, as the world’s oil supply is exhausted, the price of oil will inevitably increase.
  5. Easy trading concept. Although it is a good idea to work with a broker or trader who can show you the ropes of futures investing, it is relatively easy to get started. Anyone who takes a little time to research the process can figure it out and develop a trading strategy.

Disadvantages of Oil Futures

Although investing in oil futures has many benefits, there are a few concerns that investors should be aware of before they get started:

  1. Volatile. All futures are volatile investments and oil is no exception. No one can predict with any degree of certainty what the price of oil is going to be tomorrow, next week, or next month. Also, changes in the value of a future tend to change significantly more than stocks. In the past year, the price of crude oil futures have risen 33%, which has been a blessing for investors. However, this shows how sensitive they are and they could easily lose the same value extremely quickly.
  2. Expiration date. All derivatives expire on a certain date. If you fail to exercise them prior to that date, they become worthless. They also lose a lot of their value as you approach the settlement date, so if you don’t intend to exercise the future it is a good idea to trade them at the earliest opportunity. Some investors want to hold onto their futures and sell them at a higher price later on, just like they would with stocks. However, they fail to grasp that holding onto the futures causes them to lose their value even when the price of oil remains unchanged. This is because the futures are less appealing to speculators who need time to exercise their strategy. Oil futures are usually listed as being good for up to 9 years, but you can buy them on the market any time before they expire. If you purchase a future within a couple of months of its expiration date, that may not leave you enough time to trade successfully.
  3. Unexpected supplies. Although the world’s supply of oil is limited, new sources are still found. Newer approaches such as offshore drilling have also increased the supply of oil. Although they have not been enough to significantly reduce oil prices, they could reduce it enough to cause futures investors to lose money on a transaction.
  4. Sensitivity to a number of issues. The price of oil is heavily influenced by many factors other than supply and demand. For example, it is often affected by the agendas of current and aspiring politicians, wars, natural disasters, and major news stories. Since the price of oil futures go hand in hand with the price of oil, these events make investing in oil riskier than many other investments.
  5. Threats from substitutes. As oil prices increase, companies and politicians look for new sources of energy. New options such as green energy become even more important as concerns for the environment and global warming increase. Alternative energy sources could drastically reduce the cost of oil if they became popular enough (i.e. less demand for oil). It is unlikely that this will happen in the near future, but it remains a threat.
  6. Exhaustion of oil. The depletion of the world’s oil supply remains a benefit for investors as it continues to drive prices up. However, one day the supply of oil will be used up completely and oil futures will obviously become worthless. This is not projected to happen for at least another forty years. However, oil consumption is rapidly increasing so we can’t be sure when the supply will be completely used up. Although this may not be an immediate problem, it is something that investors need to be wary of.

Using Oil Futures in Your Portfolio

If you decide to take the leap into oil futures, you will first need to open an online futures account (approval isn’t guaranteed). Once you’re all set up, you will need to be ready to think on your feet. Since futures expire and lose much of their value near their date of expiration, you are going to have to move quickly.

To help you make quick and intelligent decisions, it is imperative that you do your research. Analyze supply and demand charts, and consider other factors including weather patterns, political turmoil, and current events on a daily basis. All of your research should revolve around one thing: the future price of oil.

Also, oil futures provide an investment strategy even for those who believe the price of oil is going to decrease. By short selling oil futures, you are effectively betting against the future price of oil.

One other important note to keep in mind is that purchasing an oil contract gives you ownership of 1,000 barrels of crude oil. This means that for every one dollar change in the price of oil, you will have a profit or loss of $1,000. This aspect of futures even further adds to the risk and volatility of investing in oil futures.

If you forecast the trend correctly, you will find yourself in a lucrative position. But the opposite is true as well. Make sure you know what you are doing before you start investing in oil futures.

Who Is Most Likely to Invest in Oil Futures?

Many investors can benefit from investing in oil futures. They either want to use the contract in their personal investment portfolio or perhaps plan to exercise the future to lock in the price of oil. Some of the most common investors include:

  1. Institutional investors who can afford to have a short-term focus. Mutual funds, hedge funds, banks, and some other institutional investors often use oil futures in their portfolios. They are eager to take advantage of any investment with high profit potential. Some funds, such as exchange-traded funds (ETFs), may specialize in oil or energy investments. These investors can afford to have short-term assets in their portfolio and take on significant risks. However, investors who need to focus on the long-term or need to be more conservative with their portfolio are not likely to invest in oil futures (e.g. not suitable for pension funds or insurance companies).
  2. Wealthy investors. Investors with large amounts of money have the opportunity to profit from trading crude oil futures. They can afford to take the risk of losing a lot of money and are drawn to the opportunity to make large profits. They are especially interested in purchasing these futures when it looks like oil prices are going to increase significantly.
  3. Companies or organizations with oil as a major expense. Many companies have much higher expenses when oil prices increase and may purchase futures to lock themselves into lower prices. Oil is one of the biggest expenses for airlines, utility companies, refineries, and large trucking firms. They often want to hedge their risk by buying oil futures so that they can be locked in to purchase oil at lower prices, especially when they fear gas prices rising.
  4. Other oil companies. Oil companies may actually purchase each other’s futures so that they can purchase oil at lower prices than the market rate and sell it on the open market. Who is better at predicting changes in oil prices than the oil companies themselves?
  5. Individual investors. Shrewd investors are eager to pursue any strategy that gives them the opportunity to make a lot of money. However, many are hesitant to invest in oil futures due to the high level of risk involved.

When to Invest in Oil Futures

Many investors want to take advantage of oil futures but are hesitant to make the plunge. Hesitation is dangerous in this market. If you are serious about investing in oil futures, you need to understand that almost 100% of the game is timing.

First, make sure you understand the trading hours that are best suited for purchasing oil futures, which are generally between 9 am and 12 pm EST. This is the busiest and most liquid time of the day for traders with the smallest bid-ask spreads.

Secondly, get an idea of when the price of oil is likely to increase. Here are some things you should think about before you invest in oil:

  1. What is happening to the supply of oil? This is probably the most important question to ask. One of the main reasons why oil prices are spiking right now is because the world’s oil supply is becoming exhausted at an alarming rate. However, you should be aware of efforts to find new sources of oil such as through offshore drilling. This could increase the short-term supply of oil and temporarily change prices. Temporary reductions in price are extremely significant when you are buying futures that expire in a given period of time. The Organization of the Petroleum Exporting Countries (OPEC) tries to keep oil prices consistent, but they clearly have a hard time doing so. Also, OPEC nations make a lot of money selling oil, so their impartiality in keeping prices at a reasonable level may be called into question.
  2. Political developments and wars. Concerns over the wars in Afghanistan and Iraq contributed to increases in the cost of oil in 2008. Political instability has a significant effect on the price of oil, especially in countries where oil is a major source of revenue. Make sure to follow these events because changes in the price of oil are not usually far behind.
  3. Economic variables. The recession has caused many people to drive less often. Employees are even trying cut the cost of commuting to work (e.g. telecommute a couple of days a week to save money on gas). Airlines see less business as well. There is an overall decline in the demand for oil, which does affect its price. While these effects are longer term and more difficult to predict, they should be taken into account while you decide whether or not to purchase oil futures.
  4. Time of year. The time of the year has a strong impact on the price of oil. During summer months, there is a high demand for oil as people travel more. Of course, the winter is probably the biggest time when oil prices spike as consumers heat their homes and find ways to keep warm in the winter cold. Buying longer term futures prior to these months may provide an opportunity to profit when they actually come around.

Final Word

Investing in oil futures can be a great strategy. They are opportunities for investors to make a lot of money, but they are also very risky. Before you start investing in oil futures, make sure you know what you are doing. You are either going to make a lot or lose a lot in these markets. Know what affects the prices of oil and when the best time to purchase is. Even the professionals get this wrong, so be realistic with yourself before you commit to investing.

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