Time to Get Long Black Gold? How Option Spreads Can Pay Off

Despite Monday's horrific stock market sell-off it looks as if crude oil hung in there quite well. Crude closed Monday at $58 and change. Big oil names such as Chevron (CVX), Exxon (XOM), ConocoPhillips (COP), Frontline (FRO), Nordic American Tanker (NAT), and Valero (VLO) sold off far worse than crude oil.

The overall market and crude have traded similarly over the last month as the Google chart shows below.

Crude may be recovering due to speculation that the economy is getting better, or possibly due to fears of inflation and a weak dollar. Whatever the reason, crude is trending up. I certainly don't think we'll see $140 crude but I believe $70-$80 crude isn't out of the picture by peak driving season. The current Bull to Bear Ratio (as defined here) on the USO is 9:2 is up from 8:3 last week.

I have two Gas Guzzling SUVs, therefore I like to hedge myself whenever possible. A way to hedge my expensive driving habit, is to profit off of crude oil increasing. Since I am speculating, I like to play vertical call option spreads, ones with big upside and minimal downside. Some option spreads I am playing with involve two crude oil ETFs, the USO and the UCO (double leveraged crude oil ETF - dangerous!). As we can see from last season, Crude peaked in July, therefore I speculated with the option contracts for the July expiration.

Yesterday I bought the July 35 USO contract and sold the July 40 USO contract for a difference of $90 per contract. If the USO gets above $40 by July's option expiration I will make $410 per contract ($500-$90). Since my cost is only $90 per contract, In order to break even I need the USO to get to $35.90. I believe this is feasible, as it is less than 12% higher.

The other call spread I opened yesterday was for the UCO. I bought the July 11 for $85 per contract and sold the July 15 for $30. The downside involved in this contract is $55 per contract with an opportunity to get $400 per contract (net of $345 or 600%+).

There are many other crude ETFs that are plenty volatile to fetch nice option premiums on, these are just two. I used this strategy last summer as the price of crude kept rising, and it paid off BIG!

Disclosure: Long GOOG, USO, UCO, FRO.

Comments

[CO2:]

Thanks for the contemporary USO>UCO strategy. As far as your boast of owning a couple gas guzzling dinosaurs, I'd suggest getting in line for the government's cash-for-clunkers program, too.

May 12 10:15 AM

[JCL:]

Nice work. Since oil is traded in USD the price of crude is currently tied to the value of the dollar. In the last several months when we saw the USD gain much strength oil also followed. Now with the dollar showing signs of weakness once again oil is again gaining value.

As you showed in your chart above how crude is correlated to the overall market once this rally subsides we will again see lower price in crude and the dollar continue to gain strength.

Peace, mir, paz,
-JCL

May 12 10:17 AM

[Whippet:]

Thanks for the article! Good word on UCO- it has nice open interest and volume; I'll look at some plays. I am also currently in a USO spread play using 2011 LEAPS at higher strikes (45/50). Bought in at 23, so I've already seen a 100%+ return. The longer plays also take into consideration the futures contract backwardation/contango relationship. When contango (carry trade) exists, like now, it puts significant downward pressure on USO, since it rolls near month into far month contracts monthly and takes a capital loss. When backwardation returns, as I am fairly certain (fundamentally) it will before 2011, USO gets a big boost.

May 12 11:09 AM

[bjc:]

Since when is 150 points a "horrific stock market sell-off"? Get real.

May 12 11:09 AM

[Marco Hickey:]

You're right not horrific at all... Just trying to "spice" up the article though... :)


On May 12 11:09 AM bjc wrote:

> Since when is 150 points a "horrific stock market sell-off"? Get
> real.

May 12 11:24 AM

[daniel3582:]

Good idea, Whippet... I had a similar idea. When I found that the January 2011 ATM contract was trading at around $800/contract, I scratched my head. Did I really believe that USO could make it above $38 by 2011? Uh, yeah. I bought a protective put, too.

In the meantime, I've been selling front month bear call spreads at high points, and bull put spreads at low points to give me a steady income that is secured against the underlying long contracts. A slightly more exotic calendar spread. More protection.

It's a no-brainer.

May 12 12:10 PM

[joseph78:]

Well what about the fact that USO and crude are correlated in a very strange and unpredictable way? I remember selling USO puts when oil was around $38 and USO was around $32 and I ended up selling USO for $24 when oil was $42 in 2-3 month. Are we guaranteed that USO will be over $40 if crude is $70-$80 ? Now I understand that USO is a different instrument which tracks oil futures, but I feel a bit cheated because I did a right move in terms of betting on oil, but a very bad move in terms of picking USO as my instrument. After that trade I am staying away from oil.

May 12 02:15 PM

[Larry House:]

I think the oil price is a bit premature. I will, however, be buying on a pullback.

May 12 02:17 PM

[CoverIsBetter:]

Hickey, is that a bar in your picture background? Please tell me you weren't drinking while writing this recommendation.

I am all aboard this 35/40 spread for USO. See you at $5.00 on the spread.

May 12 03:12 PM

[Marco Hickey:]

Not trying to boast about it, and my SUV's are not dinosaurs... I just remember last summer a lot of people complaining about the price of gasoline, however I did not complain at all, as I implemented this strategy. I was making more $ from my "hedge" than the extra $ spent on gas. I know I am not the only person with a gas guzzler, so other people with gas guzzling cars may find this article helpful.. That is if they're worried about gas prices rising in the near future, and can risk the $.


On May 12 10:15 AM CO2 wrote:

> Thanks for the contemporary USO>UCO strategy. As far as your boast
> of owning a couple gas guzzling dinosaurs, I'd suggest getting in
> line for the government's cash-for-clunkers program, too.

May 12 03:14 PM

[long roh:]

Be careful with daily leveraged plays like UCO. They suck in the long term because they are "path-dependent." In other words, the compunding of daily returns tends to magnify the transactional friction that these leveraged ETF vehicles incur. FAS/FAZ is a notorious example.

My guess is that you probably need a good smooth uptrend to make a decent risk-adjusted return on that UCO play. If crude is volatile between now and then, the path dependency issue will be a killer. For example, compare DBO to UCO since UCO's inception. DBO is basically flat, whereas UCO is down 50%. This is not a function of leverage (UCO would be near flat), it is a function of path dependency (plus the contango/backwardation distinctions between DBO and UCO). Caveat emptor.

May 12 04:26 PM

[Marco Hickey:]

HAHA! It's refreshing to see some humor for once on these comments.

As for long roh's comment you are right. I debated using UCO as an example but the premiums on the ETF's are so juicy they are hard to resist. With $55 to the downside and if crude does take off the ETF should pay off in the shorter term (3 months).

I actually just published an article about how dangerous these leveraged ETF's are check it out at: optionmaestro.blogspot...


On May 12 03:12 PM CoverIsBetter wrote:

> Hickey, is that a bar in your picture background? Please tell me
> you weren't drinking while writing this recommendation.
>
> I am all aboard this 35/40 spread for USO. See you at $5.00 on the
> spread.

May 12 05:10 PM

[OilFinder:]

Anyone going long on oil should be very careful:
europe.theoildrum.com/...

May 12 09:29 PM

[isaac the t...:]

Try using OIH (oil services ETF) for these options trades.

May 12 11:39 PM

[Popeye1250:]

Here we go again!
Everytime NAT puts out more shares to the public like they did yesterday at 3.5 million shares the shares get diluted and the stock price falls back down to $22-$23 per share in a month or so just like clockwork.
I'm selling my shares today (wed.) and waiting for a month or two to buy back in.
This is what, the third time they've done it in a year and a half I believe.
If the shares keep getting diluted like this twice a year how much is the *true value* of the shares? Certainly not $30 per share.

May 12 11:48 PM

[realold:]

Absolulely right about others with SUVs needing a strategy. In my family, my mother (84), son and wife and three grandchildren live with my wife and I, so that all save money (mom has none, son trying to get enough to buy a house with good down payment while paying up on underwater mortgage/house he is renting out - not cutting out like many irresponsible people).. So, all eight of us, including three car seats, should pile into the peop
Smart Car to go anywhere? Anti-SUV types have no clue or compassion for the rest of the world or how/why we live. They should stay out of my business and worry about paying their bills. Sorry for the rant, but I have had it with these idiots.

On May 12 03:14 PM Marco Hickey wrote:

> Not trying to boast about it, and my SUV's are not dinosaurs... I
> just remember last summer a lot of people complaining about the price
> of gasoline, however I did not complain at all, as I implemented
> this strategy. I was making more $ from my "hedge" than the extra
> $ spent on gas. I know I am not the only person with a gas guzzler,
> so other people with gas guzzling cars may find this article helpful..
> That is if they're worried about gas prices rising in the near future,
> and can risk the $.

May 13 12:01 PM

[Popeye1250:]

Pardon me, with this "additional" 3.5 million shares that NAT put out on the market yesterday I wouldn't be at all surprised to see the shares go to the $18-$20 level as opposed to $22-$23 per share.
Dilution is dilution.

May 13 12:21 PM

[HardwoodFlo...:]

How is it that the Oil markets can seemingly defy the news coming out. It seems odd to me that a market with going inventories, decreased demand (todays retail info), and a global slow down (where Europe still has a way to go) can persistantly go up?

You have to fear the ol' trade of last year. Bet the dollar down and oil up. Then, because input costs climb, short the stock market predicated on the idea that the margin for companies producing products will shrink. Ultimately then the consumer will get hit on the back side (because of rising goods prices) increasing the likely hood of a prolonged recession whereby a consumer (now hit with wage issues- decreased hours and earning potential) will have to retreat further into their hole. It has the set up of a continued recession into the another depression.

It is one of the trade scenarios out there. One that we lived through last summer, that is why I believe their needs to be a raise in the margin requirements for commodities.

May 13 12:26 PM

[sonearsofar:]

Here's an idea to avoid potentially rising costs from owning two SUVs: Sell them. Stop being a selfish jerk, and leave some oil for other humans now and in the future, as well as decrease your GHG pollution.

May 16 10:24 PM

[Marco Hickey:]

So have you traded out of this yet? As of today I traded out of a few of the contracts for a 396% gain.


On May 12 03:12 PM CoverIsBetter wrote:

> Hickey, is that a bar in your picture background? Please tell me
> you weren't drinking while writing this recommendation.
>
> I am all aboard this 35/40 spread for USO. See you at $5.00 on the
> spread.

Jun 11 11:18 AM