CRUDE OIL OPTIONS: BUYING PUTS
Let's say that you believe crude oil is overbought, perhaps because you believe that global economic activity and hence
energy demand will be less than generally expected. Not wanting to guess the top, you first wait for technical weakness
in price that will provide the signal to short the market at which point you'll look to buy a crude oil put option.
By the end of October, this has happened: crude oil closed down sharply to settle at a new recent low. (See chart at right.)
The first step of the
purchase decision
is to determine the maturity of the put option: it must be long enough to capture the anticipated price drop.
The December 2009 crude oil put options expire in
just over two weeks and
you feel that's sufficient. The second step is determining the strike price.
December crude oil put options are available across a wide range of strike prices, each having a different cost.
(See table at right.)
Reading Crude Oil Option Prices
Crude oil options are priced in dollars (up to two decimals) per barrel. One crude oil option can be exercised into one
crude oil futures contract and since each contract is based on 1000 barrels of crude oil, the option price must be
multiplied by 1000 to get a corresponding dollar value and every dollar change in the price of the option or the underlying
futures for that matter is worth $1,000 per contract.
For example, the December crude oil put option struck at 7700 meaning $77.00 per barrel, settled at 2.82 meaning $2.82 per barrel.
The dollar value of this option is $2.82 x 1000 = $2,820. This put option is at-the-money
since the December futures contract settled the day exactly at $77.00 per barrel. Notice that the futures closed
sharply lower over the day by $2.87 per barrel pushing all put option prices higher but that the option prices moved by less
than this amount. In fact, this at-the-money put option rose by just $1.15 per barrel.
As is evident in the table, as the strike price of a put option is raised,
its price increases
as does its sensitivity
to movements in the price of the underlying futures.
Choosing the Strike Price
This requires balancing risk with potential return. The former is simply the cost or purchase price of the option
along with brokerage commission and other trading fees. For example, if you want to risk at most no more than $1,200
on a December crude oil put option, then only those options having a strike price of 7250 or lower would be acceptable.
The potential return is based upon your expectation of how far crude oil prices will rally. A useful reference is the
break-even price.
The break-even price of a put option
is calculated by subtracting the option cost and paid trading fees from the strike price.
Consider, for example, the December crude oil put option struck at 7550. If it is purchased at the settlement price shown, then the break-even
price of the December futures at option expiration is calculated as:
75.50 - 2.13 - fee value = 73.37 - fee value.
At option expiration, December crude oil futures must be below this break-even price in order to
profit on the option trade.
So, you will only consider put options that have a break-even price above the price to which you expect
crude oil will fall. For example, let's say that you do not expect the December futures to fall much below $70.00 per barrel by option
expiration. Based on this, you would only consider buying put options having a strike price of 7100 or higher since otherwise the break-even price
is too low.
What remains is the range of acceptable options. In this case, for an investment of at most $1,200 and with an expectation that December
crude oil will fall to at most $70.00 per barrel by option expiration, the put options having a strike price within the range of 7100 to 7250
would be acceptable to purchase.
After the purchase, you will need to manage the option position.
What if there are no remaining options that are acceptable after considering your desired risk and price expectation? Then you
can consider buying a more expensive put option and manage the risk, or
you can consider buying a bear put spread.
Bear Put Spread
When buying a bear put spread, both strike prices should be above the price to which
you anticipate the futures will fall by the time the options expire, in this case, $70.00 per barrel. Based on this, there are several spreads
that can be purchased. For example, the 7300/7400 bear put spread has a value of 1.57 - 1.26 = 0.31 = $310 plus commission and fees.
If December crude oil futures is below $73.00 per barrel at the time of option expiration, then this spread will close
at its maximum value of $1,000 (calculated as $1 per barrel x 1000 barrels). If crude oil is above $74.00 per barrel, then this spread will expire worthless.
Stepping up the strike prices will increase marginally the cost of the spread, but the chance of the maximum value
being earned is greater since crude oil need not fall so far. For example, the 7400/7500 bear put spread has a value
of 1.93 - 1.57 = 0.36 = $360 plus commission and fees. Crude oil need only fall below $74.00 per barrel at the time of option expiration
to earn the $1,000 maximum value of the spread. If crude oil is above $75.00 per barrel, then this spread will expire worthless.
As you can see, spreads can be constructed at relatively little expense. You can risk more on a spread in return for greater
potential payout by increasing the gap between the two strike prices. For example, the 7300/7500
bear put spread has a value of 1.93 - 1.26 = .670 = $670 plus commission and fees but the maximum value is $2,000
and will be earned if December crude oil futures is below $73.00 per barrel at the time of option expiration.
Because the market for option spreads is generally less active than the market for individual options,
you will likely have to pay a slightly higher price in order to effect the purchase. After the purchase,
you will need to manage the option spread position.
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