CRUDE OIL OPTIONS: BUYING CALLS
Let's say that you are bullish on crude oil but have been waiting for a minor sell-off in order to
get long this market at a favorable price. At the end of October, this has happened. (See chart at right.)
You expect that crude oil will soon recover and break to new highs and wish to buy a crude oil call option.
The first step of the
purchase decision
is to determine the maturity of the call option: it must be long enough to capture the anticipated price rally.
The December 2009 crude oil call options expire in
just over two weeks and
you feel that's sufficient. The second step is determining the strike price.
December crude oil call 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 call 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 call 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 taking all call option prices lower as well but that the option prices moved by less
than this amount. In fact, this at-the-money call option fell by just $1.72 per barrel.
As is evident in the table, as the strike price of a call option is raised,
its price declines
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 call option, then only those options having a strike price of 8150 or higher 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 call option
is calculated by adding the option cost and paid trading fees to the strike price.
Consider, for example, the December crude oil call option struck at 7850. If it is purchased at the settlement price shown, then the break-even
price of the December futures at option expiration is calculated as:
78.50 + 2.15 + fee value = 80.65 + fee value.
At option expiration, December crude oil futures must be above this break-even price in order to
profit on the option trade.
So, you will only consider call options that have a break-even price below the price to which you expect
crude oil will rally. For example, let's say that you do not expect the December futures to rally much above $84.00 per barrel by option expiration.
Based on this, you would only consider buying call options having a strike price of 8300 or lower since otherwise the break-even price
is too high.
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 rally to at most $84.00 per barrel by option expiration, the call options having a strike price within the range of 8150 to 8300
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 call option and manage the risk, or
you can consider buying a bull call spread.
Bull Call Spread
When buying a bull call spread, both strike prices should be below the price to which
you anticipate the futures will rise by the time the options expire, in this case, $84.00 per barrel. Based on this, there are several spreads
that can be purchased. For example, the 8000/8100 bull call spread has a value of 1.60 - 1.30 = 0.30 = $300 plus commission and fees.
If December crude oil futures is above $81.00 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 below $80.00 per barrel, then this spread will expire worthless.
Stepping down 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 rise so far. For example, the 7900/8000 bull call spread has a value
of 1.95 - 1.60 = 0.35 = $350 plus commission and fees. Crude oil need only be above $80.00 per barrel at the time of option expiration
to earn the $1,000 maximum value of the spread. If crude oil is below $79.00 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 7900/8100
bull call spread has a value of 1.95 - 1.30 = 0.65 = $650 plus commission and fees but the maximum value is $2,000
and will be earned if December crude oil futures is above $81.00 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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