Trades

A Trade to Counter the Incredible Oil Price Rally

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With the Green New Deal, political talking points around “bringing coal back,” and the U.S. pulling out of the Paris Agreement, it’s easy to forget that the world still runs on oil.

Prices for crude had been in a freefall late last year as economic tensions flared up across the globe. But so far in 2019, they have been on fire:

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The latest news out of this sector came from The U.S. Energy Information Administration. The EIA reported a huge drawdown on gasoline stockpiles last week. This sent crude prices up yet again, despite crude inventories growing. The idea is that despite more crude in reserves, demand is going to grow.

But that’s not the only news spurring oil prices higher. OPEC announced four-year low production figures yesterday. Production fell to around 30 million barrels per day – a rate not seen since early 2015.

The shrinking production and supply come as Venezuela engages in a nasty civil war of sorts. The country has been hit hard by food shortages and political unrest with two leaders claiming the presidency.

Further geopolitical pressure continues to settle on Saudi Arabia’s Crown Prince, after the brutal killing of Washington Post journalist Jamal Khashoggi.

Between the two countries, Saudi Arabia and Venezuela make up more than one-third of the oil production of OPEC. And we all know what effects politics have on oil prices.

So, it seems oil’s 2018 freefall is well and truly over. Prices and demand seem to be rising and supply shrinking… or at least will be. But not so fast.

The main driver of oil prices has always been consumption. Yes, supply matters greatly. And political situations certainly affect oil prices. But with the US and Russia’s production increases over the last several years, OPEC’s dominance has abated significantly.

And when we look at the consumption side of this coin, the truth gets uglier.

Europe is suffering early signs of serious economic problems. Germany – the industrial powerhouse of the continent – is reporting manufacturing slowdowns as bad as 5%, with no indication of a turnaround.

Just last night, European leaders agreed to give the UK another six months to find some better way to deal with the looming Brexit crisis because as German Chancellor Angela Merkel put it “not because of British demands but for our own interest.” In other words, because the economy is already on rough soil back home. No point in adding a Brexit-induced recession to the mix just yet.

So, clearly, European consumption is already slowing down… even without the commitments, those countries are still keeping to the Paris Agreement.

Here in the US, the situation doesn’t look a lot better. With another round of trade wars with Europe already on the table and continuing talks with China with no agreement even outlined, our own economic worries come to light.

The FOMC announced last month that it won’t hike interest rates at all in 2019, after saying it would late last year. The reason is clear, the economy doesn’t appear strong enough to the Fed to go through with them anymore.

Now, none of this is to suggest that there’s sure to be a recession or a serious economic downturn worldwide. But it does play into the argument over oil’s true value.

The Trump Administration may be on the side of fossil fuels. But it alone can’t prop up their use. If the economies in the developed world do face economic turmoil of any sort – which they already have – the gains in 2019 for oil prices will almost definitely disappear.

This gives us a short-term trading opportunity. Oil’s rally should more than tail off soon. A correction is overdue. It is only a matter of how much of a correction we’ll see.

Fortunately, options traders don’t have to bet the farm or gamble on a major downturn to profit from it. There’s a strategy that plays this predicted movement perfectly.

A Strategy For Oil’s Near Term Correction

A bear put spread is a type of options trade involving two put contracts. The way it works is by buying a put option with a strike price near the current price of the underlying stock you expect to fall. Then, you sell a second put option to offset some of that cost.

This strategy gives you exposure to the downward price movement of the stock, without all the risk of either shorting it or buying puts straight up.

In exchange for lowering your risk, the maximum profit of a bear put spread is capped. Meaning if share prices of the underlying equity collapse completely, there’s only so much you could make. But in the case of oil – which is unlikely to approach December lows or worse anytime soon, this strategy makes the most sense. The tradeoff favors a smaller, yet substantial enough, correction.

You can see the risk-reward breakout here:

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Source: The Options Industry Council

As you can see, if shares go up, the trade results in a total loss. Yet, the amount at risk is significantly reduced from other bearish options. However, if shares fall, profits grow the whole way until the underlying stock falls to the lower of the two put strike prices.

Let’s look at a real example using this oil correction prediction.

A Specific Trade on Oil

The easiest way to gain exposure to oil prices is through the US Oil Fund ETF (USO). This fund mirrors price movements in crude oil. You can see, it trades just the same as the commodity (as seen above):

Screen Shot 2019-04-11 at 2.44.49 PM

So, this is the best tool to use a bear put strategy on. If oil does correct, so will this ETF.

A trader looking to do just that could buy a May 17 $13.50 put for $0.55 per share and sell a May 17 $12.50 put for $0.16 per share for a cost of $0.39 per share. Since each contract is worth 100 shares of USO, that’s a net debit of just $39.

That’s all the trader could lose on this specific trade. To find his potential profit, take the difference in strike prices ($13.50 – $12.50 = $1) and subtract the cost ($1 – $0.39 = $0.61). That’s a total maximum return of $61.

Of course, as with any options trade, a trader can always scale up his total investment size by buying and selling more contracts… as long as the same amount is bought and sold.

So, the trader using this specific trade would be looking at a maximum potential return of $61 per contract in exchange for a risk of just $39 per contract. That represents a $156% return on the amount at risk.

For this trade to work out and return this full profit, shares of USO would have to fall to at least $12.50. That’s just a 5.4% correction between now and May 17. In other words, oil would only have to retrace a tiny fraction of its 42% rally over the last few months.

This trade offers short-term profit potential for a commodity that all can see has gone up too much too fast, especially considering the global economic situation even the Fed acknowledges.

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