How to Trade Oil Options
If you are reading this guide on a computer, laptop, or mobile device the chances are you are enjoying some of the comforts of modern-day life. And much of that comfort stems from a single finite commodity — oil.
Although there are hundreds of other commodities that make modern life possible, oil plays a larger role than most. It moved the world into the industrial age and is now relied upon more than ever. It is due to the world’s reliance on this liquid gold and its intricate ties to the global economy that some investors are able to analyze supply and demand imbalances to predict future prices.
However, even if future prices could be predicted, many investors are stuck with either oil futures, oil-related stocks, or oil ETFs. While oil futures could certainly be used to lock in future prices, there is a level of commitment that comes with oil futures that may deter most investors. After all, no one can predict the markets 100% of the time. So, what if an investor simply wants the option to gain exposure? This is where oil options provide the perfect answer.
Oil options contracts offer enhanced levels of flexibility when it comes to gaining exposure to the oil markets. Although commonly used by international institutions and oil companies to hedge existing positions, the same principles can also be leveraged by retail investors.
Although thought of as a slightly more complicated investment product, wrapping your head around how these products work is well worth the effort. Options contracts open up a new world of investment strategies that most investors don’t even know exist.
In this guide, we will uncover exactly what oil options contracts are, what advantages these products offer, and outline three steps that will allow any investor to start trading.
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What are oil options contracts?
Before complicating things with oil, let’s have a refresher on what exactly an options contract is.
An option is a type of contract that states the holder has the right, but not the obligation, to buy or sell an underlying asset at a predefined price on a pre-defined expiration date in the future. The pre-defined price is more commonly referred to as the strike price.
With that description, it is easy to confuse options contracts with futures contracts, as both give the holder the right to buy or sell an underlying asset. However, the key thing to remember is that, with options, there is no obligation to buy or sell. The decision of whether to buy or sell is better known as “exercising” a contract.
Due to this flexibility, options are often compared to insurance policies as they can be used to hedge against the rise or fall of an underlying asset. For the advantages that this hedge offers, option buyers must pay an upfront cost to option sellers — known as a premium.
Although there are important differences between futures and options, options contracts are still a type of derivative product that derives value from an underlying asset. In the case of oil options, it would be logical to assume that, just like oil futures, oil options would derive value from spot crude oil prices. However, this is not the case.
Instead of providing the option to buy or sell crude oil, oil options provide an option to buy or sell oil futures contracts. In other words, depending on the type of oil option, a trader can either go long or short oil futures.
How do oil options work?
To truly understand the advantages of oil options it is useful to break each contract down into the parties involved.
Every type of options contract, whether for stocks or oil or Bitcoin, involves two parties: (1) one party that creates the option contract — often referred to as the ‘seller’ or ‘writer,’ and (2) one party that buys the option contract — often referred to as the ‘buyer.’
As previously mentioned, to hold an option, the buyer must pay a premium to the seller.
With that relationship in place, there are two types of options contracts that investors can either buy or sell: (1) calls and (2) puts.
A call is an options contract that gives the buyer the right, but not the obligation, to buy an underlying asset at the agreed strike price. As we’ve previously mentioned, the underlying asset of oil options is oil futures. Therefore, on the date of expiry, a call option holder can exercise and buy a long position from the seller in the underlying crude oil futures market.
A call oil option is often used if an investor is confident that the oil market price is going to increase above a chosen strike price. Alternatively, a call oil option could also be sold if an investor believed that the market price was going to decrease below a chosen strike price.
The other key type of options contract is known as a put. In comparison to calls, a put option gives the buyer the right, but not the obligation, to sell an underlying asset at the agreed strike price. This means that on the date of expiry, a put oil option holder can exercise and take a short position in the underlying crude oil futures.
A put oil option is often purchased if an investor holds the thesis that oil market prices are going to fall below a chosen strike price. Alternatively, a put oil option could be sold if an investor believed that the market price was going to climb above a chosen strike price.
As you may have gathered, the profitability of call and put oil options revolves around the strike price — the agreed price that oil options contracts will be exercised. Using that relationship, options are usually classified in one of three ways: (1) at-the-money, (2) in-the-money, or (3) out-of-the-money.
For oil calls, an option is in-the-money if the underlying futures price is above the strike price. A call oil option is out-of-the-money if the underlying futures price is below the strike price. Finally, a call oil option is at-the-money if the underlying futures price is the same as the strike price.
While at-the-money is the same for puts, the in-the-money and out-of-the-money classifications are reversed. A put oil option is in-the-money if the underlying futures price is below the strike price. A put oil option is out-of-the-money if the underlying futures price is above the strike price.
Unfortunately, there is a lot of terminology when it comes to options. All of the in-the-money, strike price and out-of-the-money jargon can make things more confusing than they actually are.
Above all the technicalities of oil options, one of the most important things to remember is that in all of the call-and-put scenarios outlined above, an options contract simply allows an investor to potentially lock in a difference between the underlying oil futures price and a chosen strike price. The larger the difference the greater the profit.
If the market moves in a manner that is unexpected, a call or put option simply expires worthless, and only the option premium needs to be paid.
Example of a call & put oil option
To help understand oil options, there is nothing better than to follow a numerical example. Outlined below, we have an example of both a call and put oil option.
Call oil option example
Contract type: Call
Contracts: 1 (equivalent to 1,000 bbls)
Underlying: WTI crude oil futures
Strike price: $95
Premium: $2/bbl (or $2,000)
Expiration: 07-25-2022 at 08:00:00 UTC
On July 25, 2022, the call option holder has the right to buy WTI crude oil futures for a strike price of $95. If on July 25, 2022, the market price of WTI crude oil futures is $100, each call option would be worth $3,000 (market price — strike price — premium* 1,000 bbls). The option holder could exercise the option and buy WTI crude oil futures for $95 instead of the true market value of $105.
Alternatively, if on July 25, 2022, the market price of WTI crude oil futures was less than $95, the contract would expire worthless and the call option holder would have lost the premium of $2,000.
Put oil option example
Contract type: Put
Contracts: 1 (equivalent to 1,000 bbls)
Underlying: WTI crude oil futures
Strike price: $95
Premium: $2/bbl (or $2,000)
Expiration: 07-25-2022 at 08:00:00 UTC
On July 25, 2022, the put option holder has the right to sell WTI crude oil futures for a strike price of $95. If on July 25, 2022, the market price of WTI crude oil futures is $85, the put option would be worth $8,000 (strike price — market price — premium* 1,000 bbls). The option holder could exercise the option and sell WTI crude oil futures for $95 instead of the true market value of $85.
Alternatively, if on July 25, 2022, the market price of WTI crude oil futures was above $95, the contract would expire worthless and the put option holder would have lost the $2,000 premium.
What Are The Benefits Of Oil Options?
Oil options are extremely flexible investment products that offer a variety of benefits for both long-term investors and short-term traders.
- Lower upfront costs. When entering an options position, a trader can only ever lose the cost paid for the option (the premium). If the market does not go in the direction that a trader expects, only the option premium is lost. If we compare the same scenario with oil futures, a trader needs to commit both an initial margin and maintenance margin to open a position. If the market moves against them, a trader may need to deposit more collateral or the entire margin balance could be forfeit.
- No risk of physical delivery. Oil options traders do not need to worry about the physical delivery of crude oil, which is sometimes required when trading oil futures. Although the majority of oil futures contracts are cash-settled, there are some, such as those traded on the New York Mercantile Exchange (NYMEX) that require physical delivery. In this scenario, for each short oil futures contract, an investor must deliver 1,000 barrels of crude oil, and for each long oil futures, an investor must accept delivery of 1,000 barrels of crude oil. Oil options remove this risk.
- Potential for greater market exposure. The leverage of an oil options contract can often be larger than an oil futures contract, which means that an investor may be able to gain greater exposure to the oil markets. For example, let’s imagine that the initial margin required to open a long oil futures contract, which represents 1,000 barrels of crude oil, is $3,000. At the same time, the premium for an option on the same futures contract could be $1.50 per barrel. An investor could buy two oil option contracts, which would represent 2,000 barrels of underlying crude oil and, therefore, gain twice as much exposure.
- Making money from premiums. Retail investors can make money from selling options contracts as well as buying them. All those selling options collect a premium for taking on the risk and do not need to pay out if the option contract expires out-of-the-money. Selling out-of-the-money options can be particularly lucrative if an investor is expecting the market to range between two levels.
- Can hedge existing positions. With oil options, longer-term investors can hedge existing oil positions. Although this is a process commonly implemented by larger hedge funds and oil companies, the same principle could be used by retail investors. If an investor holds oil stocks or has a position long oil futures but thinks that in the short to medium term prices may fall, they could enter a put option to hedge that risk.
4 Steps To Buy And Sell Oil Options
Hopefully, by now, you have gained a decent appreciation for what oil options are and exactly how they work. However, accessing and trading oil options can still be a tricky path to navigate. To profitably buy and sell oil options there are four key steps that all investors need to take.
1. Learn Oil Fundamentals
Trading oil options is an active investment strategy. Options were initially created to provide investors with the flexibility to enter the market if circumstances were in their favor. However, to know if circumstances are in your favor, a wider understanding and appreciation of oil market fundamentals is required.
Oil is one of the most widely used commodities in the world. After crude oil is extracted from the ground, it is refined, processed, and then distributed to a range of different industries such as transportation, manufacturing, and energy. Importantly, the price of oil is linked to supply and demand. It is thanks to the world’s vital reliance on oil that allows traders to profit from supply and demand imbalances.
It is the mechanisms of supply and demand that oil options traders need to gain an appreciation for. Changes to the global economy, adjustments to oil production levels, and conflicts within oil-producing countries are all examples of factors that can influence supply and demand. One of the most recent examples is the Covid-19 pandemic, which sent oil prices tumbling when restrictions were implemented but also sent them skyrocketing once restrictions were lifted.
Importantly, oil prices are typically referenced using two key global benchmarks: (1) Brent and (2) West Texas Intermediate (WTI). Brent oil is an oil benchmark that originates from the United Kingdom and is used as a common pricing point for most of Europe and Asia. Meanwhile, WTI is the second oil benchmark that originates from the U.S. Oil futures and, therefore, by association oil options, follow either Brent or WTI crude oil prices.
2. Pick A Broker And Open An Options Trading Account
The next step in the process involves finding an options trading account. Due to the complexity of options trading, brokers typically want to know a little bit more about individual investors to make sure that a level of competence has been reached.
Brokerage firms are likely to ask questions regarding your investment objectives, trading experience, personal finances, and what options you will be interested in trading. Depending on the answers provided, brokerage firms will then likely designate you with a risk level, which will determine how much risk you can take through the platform.
However, this is not a one-way process. While a broker might ask you questions, it is also important to give a brokerage firm a thorough check and get familiar with the platform. Does the broker provide useful research, market updates, and support if problems occur? A brokerage platform should be efficient to use, not make the process more difficult than it needs to be.
American vs European Options Contracts
Before choosing a brokerage, it is important to note that there are two styles of options contracts offered by the majority of platforms: (1) American- and (2) European-style options contracts.
American-style options contracts can be exercised at any time up until the date of expiry, whereas European-style options contracts can only be exercised on the date of expiry. American-style contracts are, therefore, slightly more flexible; however, for this flexibility, they are also more expensive.
Most brokerages only offer one type of options contract and, therefore, this factor can be a deal-breaker for some investors.
3. Pick Oil Options To Buy And Sell
Once an options trading account has been created, the next step is to decide what type of options contract you would like to trade. Which type of option you pick will depend on your views on where oil prices are heading in the future — which is when homework on oil fundamentals comes in handy.
If you think oil prices are likely to increase, you could buy a call option or sell a put option.
If you think oil prices are likely to fall, you could sell a call option or buy a put option. If you think oil prices could move within a range, perhaps you could profit from option premiums by selling out-of-the-money call and put options.
There are loads of options, quite literally, to think about, which is why having your finger on the pulse of the oil markets and an appreciation for oil supply and demand is so key.
4. Choose A Strike Price And Expiry Date
Once you have begun formulating a plan for the type of options contract you would like to enter, the final step in the process is to select a strike price and expiry date. These are two crucial data points for all options contracts.
For example, let’s imagine that it is April and you believe that oil is likely to be more than $100 by June. In this scenario, it could be advantageous to buy a call option with a strike price of less than $100. If the price ends up above $100, the option would expire in-the-money.
Alternatively, perhaps a piece of news is released that increases oil supply, which makes you change your investment thesis. You now believe that oil is likely to be less than $80 by June. In this second scenario, it could be advantageous to buy a put option with a strike price higher than $80. If the price ends up lower than $80, the option would expire in-the-money.
Once a strike price is chosen, the final choice comes down to the length of the oil options contract. Expiration dates for oil options range from days to weeks to months. The lower the contract length, the more risk there is that an options contract may expire out-of-the-money. Monthly and yearly expiration dates are, therefore, recommended for investors just starting within options contracts. A longer expiration date will give the price of oil more time to move and align with your investment strategy.
Wrapping It Up
Oil options are a unique and interesting way to gain exposure to oil markets. The level of flexibility and leverage is hard to beat. However, it would be unforgiving to say that this type of investment product is suitable for everyone.
Options are complex and are undoubtedly more suitable for investors or traders that are active within the markets and have the capability to watch market news and keep up to date with oil supply and demand fundamentals. Options should be given the respect they deserve, which means putting in the time and effort to learn the nuances that come with this product. Master it, and oil options could open a world of new investment possibilities.