Need An Oil Rally?

| About: The United (USO)

At last week's baseball game, my friend fretted over the slump in the price of his United States Oil Fund ETF (NYSEARCA:USO) shares. I spent the better part of an inning explaining an optimization of his covered call strategy after he expressed some frustration over his low premium yields.

My discourse on volatilities was met with some consternation. "Jeez," he says. "I don't want to spend my time playing with data. Not during baseball season. Besides, that last dip below the $40 level worries me. Oil doesn't seem to be bouncing back with much conviction."

Turns out he bought USO back in December, when oil was $38 a barrel. He picked up a couple of round lots at $12. Now, with crude dancing on either side of $40, USO shares are changing hands for $9.80 or so (if you're wondering why USO's price has fallen while oil's price has risen, blame contango).

"Buy me a hot dog," say I, "and we'll see if we can find a way to unwind this."

"Wait," says my pal, "you're not gonna tell me to hedge, are you? I don't want to put in any more money. I'm thinking if I could just get to breakeven, I'd bail."

Hmmm. USO's sunk about 18 percent from his original entry point; but from here, he'd need to see a 22 percent rally for USO to get back to his original cost basis. That's the law of recovery.

What my baseball buddy needs to do is to actually write more USO calls. Not like he's done to date, but in ratio. That means buying two calls with an exercise price near USO's current value and selling four calls with a higher strike (a 1:2 ratio call write). Ideally, the premium collected for the written calls offsets the cost of the purchased options.

Why do this? To lower his ETF's breakeven - and his bailout - point.

Bear with me. Here's what the aggregate position - together with all its debits and credits - looks like:

Long 200 USO @ $12.00

-$2,400

Long 2 October USO $10 calls @ $0.70

-$140

Short 4 October USO $11 calls @ $0.35

+$140

Net

-$2,400

Click to enlarge


Notice two things here. First, there's no net cost (barring commissions) for the ratio write. The net debit before the trade ($2,400 for the cost of the USO shares) is the same as the net debit after the trade.

Second, the risk of being short calls is completely covered. The assignment hazard for two of the $11 calls is covered by his ownership of fully paid USO shares. The other two short calls' risk is checked by the two $10 calls purchased. No margin requirement, therefore, will be imposed, though the trade still needs to be done in a margin account.

Here's how this "repair" strategy would play out by the options' October expiration date:

USO Value

At Expiration

Profit/(Loss)

On USO Shares (200)

Value of

USO $10 Calls (2)

Value of

USO $11 Calls (4)

Net Profit/(Loss)

On Position

$9.00

($3) x 200 =($600)

$0.00

$0.00

($600)

$10.00

($2) x 200 =($400)

$0.00

$0.00

($400)

$11.00

($1) x 200 =($200)

$100 x 2 = $200

$0.00

$0

$12.00

$0

$200 x 2 = $400

($100) x 4 = ($400)

$0

$13.00

$1 x 200 = $200

$300 x 2 = $600

($200) x 4 = ($800)

$0

Click to enlarge

Note that Mr. Baseball's breakeven point has been lowered from his original $12 cost basis to $11. Now he needs just a 12 percent recovery to bail out unscathed, rather than a 22 percent bounce. Still, he needs a recovery. This isn't a hedge. He, in fact, still has open-ended downside risk.

He's also given up his upside. No matter how high above his new breakeven point USO rises, his gains are checked. The best he can now hope for is a wash.

Given the hole being dug by our hometown baseball team tonight (8-13 at the top of the ninth), a wash would be a boon. Me and my friend have our rally caps on.