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

| About: The United (USO)

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.