Oil: If You Can't Beat 'em, Join 'em Using Credit Spread Options

In order to capitalize on continued rising oil prices, I entered into 2 credit spread positions offsetting each other for a net neutral cash outflow. I chose ranges about 10% from current price to expire in August. I used (USO), the oil ETF, which doesn't match the exact oil price, but tracks it accurately in lockstep with a steady ratio.

From a pure investment standpoint, yes, this is market timing. From a personal finance standpoint, this is hedging against continued high oil [gas] prices and in the event I lose money due to a rapid drop in energy prices, at least I will have a lower personal outflow for energy. If I played the opposite way, I would be compounding the pain with double increases. The trend is your friend and I am doubtful we'll see a rapid decline in oil prices given supply/demand dynamics and global political issues developing. Airlines and trucking companies hedge energy prices, why shouldn't consumers and investors?

Here's how the credit spread works:

Let's start with the bull side. You buy a call and sell a call with closer/further strike prices, and you pay a net premium outflow, but benefit from any move in stock price upward, and your profits are then capped at the upper contract you sold.

 

 

On the bear side, you sell a put and buy a put with a closer/further strike price, and you recieve a net premium inflow, but you'll be penalized by a move in the stock downward once it surpasses the strike price of the put you sold. Your losses are capped at the lowest end of the contract you bought.

Specific to USO, when it was trading at 115 yesterday, I bought 2 call contracts of Aug 125s at 3.80 each and sold 2 call contracts of Aug 132s at 2.20 for a net outflow of 1.60 each or 3.20 total. Conversely, I sold 2 put contracts of Aug 104s for 2.90 and bought 2 put contracts of Aug96s for a net inflow of 1.60 each or 3.20 total. The 3.20 in and out balanced each other out and now I have a bull position on oil for free.

 

Here's how it will work in this example:

In the event oil spikes to move USO at 132 or greater, my maximum profit is $1400 (Aug132 call options minus the Aug125 call options with 2 contracts). In the event USO drops precipitously to 96 or lower, my maximum loss is $1600 (Aug104 put options minus 96 put options with 2 contracts). If oil trades in a range without suprassing either of the inner strike prices (USO between 104 and 125 per share), nothing happens. All options expire worthless and I'm free to enter into the same position again.

Editorial Note: Article updated on 7/6/08.

Comments

[mextex]

Wow there! Credit spread net zero cash outflow. No way he do what he says in example. Buys always at lower call value and sells at higher call value, he will always be cash negative!
sold at 132, sold at 104
buy at 96, buy at 125.
Sure like to knkow how he pulls that off!

[AKJ]

The August 104s and 96s are puts. That detail isn't mentioned in the article but explains why the 96s are cheaper than the 104s. This article could have used a proofread for clarity. I think the sentence starting with "Conversely" is missing the introduction to the "bear" strategy.

Would be good to mention commission costs here too because I imagine they eat up a considerable portion of your theoretical profits and ensure you can't enter into this position for zero cost. If an option is exercised (likely if the options he sold go in the money) the commissions are even higher. Not an issue when you trade $100k+ at a time, a big issue when you trade <$1k.

[Everyday Finance]

Sure, left out the "put" in the conversely piece; thanks for clarifying for first commenter. The costs cited in the article are exactly off the Ameritrade history, so authentic. Oil's running up more, so looking good.

To address some of the concerns over commisions, etc., here are some add-on notes from the original post (I add commentary as the play evolves or comments come in at Everyday Finance):

There are some benefits to playing this with spreads as opposed to other options plays:

-buying a straight put or call opens you up to loss of premiums at expiry: 2/3 of all options expire worthless

-selling naked puts or calls leaves you with unlimited liability if a run up or down occurs. With spreads, you liability is capped.

-the liquidity requirements are drastically reduced if you cap your ends with a spread as opposed to selling a naked option.

-finally, the commission is the same for a spread as it is for a single option; you just have to pick spread in the complex option tab or equivalent with your broker.