Trades

A Play on Oil’s Freefall

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2018 has been an ugly year for commodity investors… specifically oil investors. Crude oil has officially entered bear territory, marked by its recent freefall in October and continuing this month:

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OPEC has projected this is a trend not yet over. The 15 oil-exporting countries that make up OPEC have projected continued declines throughout 2019 for oil consumption. Despite new sanctions on Iran, the world is simply oversupplied right now.

This, of course, has a reverberating effect on the market. Some, especially in the transportation industry, love when energy commodities take a tumble. It makes their costs fall. Others see a decline in oil prices and more importantly a decline in consumption to be an indicator of slumping economies.

While it’s too early to tell just how deep this crash will go, it’s clear everyone is making their moves. The last time oil fell so far, so fast, it continued for another few months.

In fact, the timing of the last fall like this matches up almost perfectly with what we’re seeing this time:

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As you can see, in October 2015, the price of crude started falling. By Thanksgiving of that year, it had already dropped 20% — similar to where we’re at today. Unfortunately for oil investors, that was only the start. Prices fell all the way from $50 per barrel to below $28, a 44% slide.

What might be even more uncomfortable to anyone long oil and a student of history is this:

“What we do know is that, despite a recent upturn, the price of oil has slumped almost 50% since last summer following the longest-running decline for 20 years.

And we know why – US shale oil, and to a lesser extent Libyan oil returning to the market, has pushed up supply while a slowdown in the Chinese and EU economies has reduced demand.

Add to the mix a strong US dollar making oil more expensive in real terms, pushing demand even lower, and you have a recipe for a plummeting oil price.”

If you didn’t know this was a quote directly from the BBC in February 2015, you might think it was from a news report today.

Supplies are up, as OPEC has noted. Economic slowdowns in China and some EU countries have kept consumption forecasts down. And the US dollar, as seen here, has been steadily climbing most of the year:

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Of course, a 44% correction would be devastating to anyone with long bets on oil. It would also most definitely signal a weak global economy. But here’s the other part of that 2015 story.

It rebounded… hard:

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Those losses at the end of 2015 were but a faint memory by summer 2016. That’s how quick this commodity can move.

As for what it will do this time… that’s less certain.

How to Play Oil’s Volatility

Oil has always been impossible to properly forecast. There are simply too many moving factors, which is why it can be so volatile. As noted above, everything from the strength of the dollar to tariffs in China to weak job numbers can cause a rupture or recovery.

That’s why anyone telling you that they know exactly where crude is headed is either lying or overconfident. But that doesn’t mean it is an impossible investment to play. In fact, this volatility presents certain options investors with a great opportunity… especially with this recent spike in uncertainty.

One strategy to play such a volatile investment is by entering a long straddle position. A long straddle is an options trade where one buys both a call option and a put option on the same underlying stock, with the same expiration date and the same strike price. Meaning, if the stock heads in either direction far enough, one of those two options will become quite valuable.

You can see how this looks in the diagram below:

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Source: The Options Industry Council

The total risk one takes on with a long straddle trade is the amount of money spent for the two options. Since the trader is only long those options, that’s all he would have to lose.

The total profit potential of a trade like this is technically limitless. Since the trade turns positive the further away from the options’ strike price goes, any major move results in a large profit.

To calculate the exact point where the trade enters positive territory, the trader would simply take the strike price and add up the two premiums he bought. If the underlying stock moves higher or lower by the total cost of the premium from the strike price, the trade hits positive ground.

A Specific Trade on Oil Volatility

Unless you want to mess around with futures contracts, one of the best ways to play any trade on oil is to look at the US Oil ETF (USO). This fund holds those futures so you don’t have to. It moves in concert with oil and is easily traded.

If you were to buy a December 21 $11.50 call on USO for $0.66 per share and buy a December 21 $11.50 put on USO for $0.67 per share, it would cost a total of $1.33 per share to enter this long straddle. Since each option contract represents 100 shares, that’s a total outlay of $133 to get into this trade.

That’s the total risk with this straddle. If oil somehow doesn’t move from here in either direction, that’s what a trader would have to lose.

If oil does move — and again, it doesn’t matter in which direction it moves — there’s a limitless profit potential. It does, however, have to move a decent amount. But as you can see from all of the above charts, that’s a distinct possibility.

For this particular trade to enter positive territory, USO would have to pass either the $10.17 threshold on the downside or $12.83 on the upside. These moves represent an 11.6% movement in USO’s price. With a full month of shopping season, year-end forecasting and continued news stories (not to mention a Fed meeting), a double-digit move for oil is certainly on the table.

Again, it doesn’t matter if oil keeps crashing like it did in 2015 or rebound back to where it was like it did in 2016. In either event, this trade would turn positive.


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