Oil, Options, Risk And Illusions

Mar. 7.12 | About: ProShares UltraShort (SCO)

Everyone knows that options are extremely attractive because of the leverage provided, and a few bucks can multiply like rabbits. Yes, I have traded options and they are viable investment vehicles, although I tend to side with the call writing approach because, unlike stocks where the probability of being right is 50/50, options carry time value which is added to the risk column if one is a buyer.

Recently I watched an interview with Phil Davis and the option trade of the day was constructed with ProShares UltraShort DJ-UBS Crude Oil (NYSEARCA:SCO) options. The strategy is to sell SCO April $30 puts and to buy the SCO April $29/$33 bull call spread - buy the $29 calls and sell the $33 calls.

Keeping in mind that oil is extremely volatile for reasons that everyone knows, the trade is a bet that oil will not go higher than $107 or so. Everyone is entitled to their opinion, and the trade may very well work, but when asked about the risk involved if oil rises, Mr. Davis stated that a trader is risking $75 per contract against a potential reward of $400. Thus, and being extremely mindful of the word "risk," I ran the numbers with one option contract using my broker's platform.

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Commissions aside, what the figures above show is that the cost would be $155, the reward is capped at $245, while a loss of $980 would ensue if SCO dropped roughly 36%. Furthermore, and in addition to the cost, the "Option Requirement" is $1,110, which is the cash required by the broker to cover the risk. Selling the "puts" decreases the cost, but increases the required cash requirements to conduct the transaction and adds substantial risk.

Considering that the price change of SCO corresponds to -2x the price change of crude oil, we can assume that an 18% increase in the price of oil would do the trick, or a rise to $123 from the current level. Is it doable? Will Israel attack Iran without notice? Any guess is as good as mine, but I am not willing to bet either way, and the reward/risk ratio does not look very appealing to me.

What if I just bought the SCO April 33 calls as a straight bet that oil will drop? I'll spend $145 more but remove the risk that selling "puts" creates.

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Then the risk would be the purchase price of $300 and the reward would hinge on how far oil would fall. In the example above, a decrease of about 13% in the price of oil to roughly $90 by the third Friday in April would put $570 in my pocket. Furthermore, the probability of either trade working is the same because it refers to the underlying security, not the option contracts.

Many have looked for the proverbial free lunch when it comes to options, and although plenty of opportunity exists, there's always risk involved, and unless one truly understands the various strategies and their shortfalls, it's best to stick with straight bets when seeking maximum profit because the risk is well understood. I know that $155 vs. $300 looks more appealing, but one must look at the complete picture.

Certainly one could get out of the "put/bull call spread" trade before it reaches the maximum damage level, but, in this case, oil could shoot up to $123 by the time one digests the first morning waffle. Lastly, let's keep in mind that option spreads are used to minimize exposure to losses which always limits profits, not to increase the reward/risk ratio.

The promise of large payouts can be found in options that are way out of the money, but the probability that the price of the underlying security will move considerably in one's favor within the time frame is very slim. That's why those options are relatively cheap, and that's how many novice traders keep feeding the system, $100 at a time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.