April 30, 2015 By Adam Feik
In the last 2 weeks, I've written about oil ETFs and broader energy and commodity ETFs. Interestingly enough, some of those ETFs have switched over to "green triangles" on their MarketClub charts, just within the past few days. Check out USO and DBE for example. DBO (the oil ETF I prefer over USO) has not yet flipped over to a long-term ("monthly") green triangle.
Another way to play oil prices
Today, I'm going to describe a slightly more sophisticated way to bet on rising oil prices. The advantages of this approach, compared to buying ETFs, are these:
• You can place fewer dollars at risk. Yet at the same time…
• You can retain reasonable upside potential, and…
• In combination, you can almost entirely protect your principal, in order to make sure you'll live to invest another day (even if you're wrong about this particular oil bet).
Here's how it works:
Suppose you believe oil prices will rebound to at least the mid- to high -70s sometime between now and December 2018. For those (like me) who are willing to admit limited ability to foresee the next 12-18 months, this gives you more than 3.5 years for your thesis to play out. Even a fluctuation into (or slightly beyond) the targeted $75-80 range during the next 3.5 years could be readily and easily converted into profits. If said fluctuation never occurs during the time period chosen, this approach is designed to limit your losses. Here's how, in 2 steps.
Step 1: Position yourself for upside
Initiate a "bull call spread" using call options on NYMEX crude oil futures. For those unfamiliar with options, stay with me. I'm going to lay out an example for you. Plus, most online brokers have plenty of educational materials about options. If, after reading this article, the strategy intrigues you, take a little time to watch some tutorials or something to get educated before placing trades.
Here's an example of a "bull call spread":
Buy one December 2018 $75 NYMEX crude oil call option at around $5.80, while simultaneously selling one $80 crude oil call option at around $4.50. The net price of this "spread" investment (which you can and should enter as a single trade) is about $1.30. Since each option contract represents the right – but not the obligation – to buy 1,000 barrels of crude, the total cost of this call option strategy will be about $1,300 plus transaction costs. That's your total investment for Step 1.
Today, the underlying December 2018 crude oil futures contract is already trading around $66.50. Your "bull call spread" is essentially a bet that Dec. '18 crude will rise to the $75-80 range (the closer to $80, the better) sometime between now and the options expiration date of 11/14/2018.
$79.80 (for example) would be a 20% move in the price of Dec. '18 crude oil, based on today's $66.50 price. If you were to consider closing out your "bull call spread" sometime before 11/14/2018, with Dec. '18 crude trading at $79.80 (which would be almost the ideal scenario), the total value of your "spread" strategy – which cost you a little over $1,300 to establish – should be around $4,800. Why? Because at that moment, you could exercise your right to buy crude at $75, and then turn right around and sell at the market price of $79.80, for a total "spread" of $4.80. Multiplying by the 1,000 barrels of crude represented by one underlying futures contract gives you a total value of $4,800… and total gains of about $3,500 in profits on a $1,300 investment (ignoring transaction costs).
Again, the bottom line is that your maximum value on Step 1 is about $4,800, which occurs if Dec. '18 oil approaches $80 and you exercise your contract at that time. Your maximum
gains, then, would be close to $3,500 in profits on a $1,300 investment (ignoring transaction costs). Your maximum losses on this step would be the entire $1,300 amount invested, which would occur if your options expire on 11/14/2018 with oil still trading at or below $75 (but note, "Step 2," below, will help mitigate that small loss). Other the flip side, if oil goes far above $80, you would sacrifice all the upside above that level (so you'd want to close out your spread at around $80 or so, then move on to something else).
Step 2: Protect your downside
For comparison's sake, let's assume you would have to invest about $17,500 in an oil ETF like USO, OIL, or DBO, in order to have the same $3,500 profit potential from a 20% rise in oil prices (since $17,500 times 20% equals $3,500).
Yet the "bull call spread" strategy above required only about a $1,300 net investment to make that kind of upside possible!
So, here's what you do. First, invest about $1,300 as described in the options strategy above (Step 1). Then (Step 2) take the difference – about $16,200 – and invest in a bond or CD that has a maturity date around November 2018 (roughly coinciding with the call option's expiration date).
Let's say you can find a bond or CD yielding about 1.5%. Over a 4-year period, that bond or CD would pay about $850 in interest. So even if you lose the $1,300 on your call option, you'll still have your $16,200 from the bond or CD, plus $850 in interest, for a total of about $17,000. Overall, then, your net risk for the whole $17,500 strategy is only about $500!
A simple – yet powerful – combination
By taking these 2 steps, you will have effectively broken your combined $17,500 investment in oil into 2 parts – one part that's responsible for your growth (by placing about $1,300 at risk), and another part that's responsible for your principal protection (by investing about $16,200 in boring bonds or CDs).
The combined result of this 2-step strategy is a $17,500 investment with a maximum 3.5-year horizon, maximum gains between $3,500 and $4,350 or so (depending on how long you continue the strategy, thereby collecting interest on the bonds*), and maximum losses of about $500. I know it's not fun to lose $500, but it beats losing $5,000 or $10,000 on DBO if your options should happen to expire with oil prices in the 20s or 30s.
I didn't invest this approach. Many of you may have seen it or even executed it before. Many professional and institutional investors invest this way. You could even build a whole portfolio this way, investing in all kinds of assets and markets for which long-term option are available! For an example of a money manager who uses this concept (normally investing in broad stock indices), see Desert Rose Capital Management. Fixed indexed annuity issuers are also said to invest their reserves in a similar manner. I've also read articles by futures traders (via subscription) describing this type of approach as a way to build your own "oil-linked CD."
*For example, if oil gains 20% in the first 6 months, you might close out the whole strategy having only earned a very minimal amount of interest. Or if you ride the strategy full term, you should collect the full $850 or so on the bonds.
INO.com Contributor - Energies
Disclosure: At the time of post publication, this contributor owned Enterprise Product Partners (EDP), but did not own any other stock mentioned. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.