Oil Spreaders Heed Schork's Call

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Includes: DBO, OIL
by: Hard Assets Investor

By Brad Zigler

Looks like somebody took Stephen Schork's advice Wednesday. Somebody bought oil options.

Maybe a little background's in order.

Schork,editor of The Schork Report energy newsletter, in an Hard Assets Investor interview ("Schork: Seeds Being Sown For Oil Rally") made a case for $60-$65 oil. That level, says Schork, is OPEC's "marginal breakeven."

Schork's not looking for oil to rally today, next week or even next month. Rather, his sights are set some 12-18 months out. Mindful of the withering effect of a year's worth of negative roll yields, Schork pooh-poohed the use of oil ETFs. No, said Schork, investors looking for a ride on the price train to the sixties should instead, consider long-term call options on oil futures.

A call entitles its holder to purchase the underlying futures contract at a pre-determined strike price anytime before the option's expiration. It's a right, not an obligation to buy futures, mind you. A holder can also sell the call to close out the contract. On Wednesday, for example, with March 2010 oil at $53.15, a $55 call could be purchased at $8.52 a barrel. Since oil futures, and their associated options, represent 1,000 barrels, that makes for an $8,520 tab. Pricy, though still cheaper than futures margin.

A gain in the underlying futures should cause, all else held constant, an increase in the call's value. It won't be a dollar-for-dollar gain, though. The option's delta expresses its sensitivity to futures. The $55 call's delta is 0.56, meaning a $1 increase in March 2010 futures translates, today at least, into a 56-cent gain in the option's premium. Delta's not constant; it changes over time in reaction to a variety of influences, not the least of which is the passage of time. At expiration, the delta's zero if futures trade at or under the call's strike price; otherwise, it's 1. Delta follows an arc as the option nears expiry.

On Wednesday, somebody bought a half dozen March 2010 calls, but they bought the $75 options at $3.36 premium and a 0.29 delta. A pretty optimistic notion for a three grand investment, right? But our buyer hedged. Our buyer didn't shell out three large for a bullish play on oil because a half dozen $90 calls were simultaneously sold, earning $1.86 per barrel. The net cost of each spread was $1,500, or $9,000 for the entire package. Here's how the deal pencils out:

March 2010 oil futures: $53.15

Strike

Price

Premium

($/bbl)

Current

Delta

Long

$75

-$3.36

+.29

Short

$90

+$1.86

-.18

Net

$15

-$1.50

+.11

The spread, now modestly bullish (note the positive delta) breaks even if March 2010 oil trades at $76.50 (the purchased call's strike price plus the net premium paid for the spread). Before expiration, however, the spread's profitable whenever the net premium (that is, the combined bid on $75 call and the offer for the $90 option) is more than $1.50 per barrel.

So, what's our trader hoping to make? Well, at expiration, the best return he or she can hope for is $13.50 a barrel if both options end up in the money. That's the difference between the strike prices minus the original net premium. That would ensue if March oil was at $90 or above.

The trade-off is limited risk. Worse case scenario? Both options expire worthless. That would happen if March oil fails to rise to the $76.50 breakeven by expiration. Then, the net $1.50 debit would be lost.

Our trader's risking $1.50 to make as much as $13.50. Baked into this is an expectation that March oil will rise, at a minimum, $23.35 per barrel from its current level. That's the move required to just break even. Moves above $90 do the spreader no incremental good, so the trader's target range for March oil is $76.50 to $90.

What do you think?

Note: Traders with more conservative objectives for March 2010 futures paired the purchase of $55 calls with the sale of the $58 calls on Tuesday to less bullish effect:

March 2010 oil futures: $53.15

Strike

Price

Premium

($/bbl)

Current

Delta

Long

$55

-$8.52

+.56

Short

$58

+$7.42

-.51

Net

$3

-$1.10

+.05

Expiration breakeven: $56.10

Maximum risk: net premium paid ($1,100) with March oil below $56.10 at expiry

Maximum profit potential: strike spread less net premium ($1,900) at expiry