Trading Crude Oil Options

Traders who have an aversion to the volatility of the crude oil futures market may want to consider trading crude oil options (long options only, of course). Trading long calls limits your downside risk to a pre-defined amount, which many investors (including myself) find appealing. The whole business of futures and options trading is very risky anyway, so a more prudent investor would rather find ways to mitigate that risk as best as possible, and this can be done by using options as an trading vehicle instead of outright futures contracts. For those who may not know, a crude oil option gives you the right (but not the obligation) to purchase one crude oil futures contract (representing 1,000 barrels of crude) at a predetermined price (called the strike price) within a specified time frame. I’m assuming that most of you reading this hub already know this, but I wanted to just bring it back out in case there were any readers who weren’t fully aware of how the whole thing works. One thing to remember about trading options in general (not just crude options) is that options can afford a trader with some fantastic leverage. I have heard of (and personally experienced) story after story of someone buying a futures option for as little as $25.00 and then seeing that option explode in value when the price of the underlying futures contract shot up. I have one of my most famous stories where I bought an Orange Juice option for about $70.00 (forgot the exact amount), and within a week’s time, that option was worth over $2,000. The cool thing about options is although they are many times priced very low (the out-of-the-money options, that is), they have amazing potential to double, triple, quadruple, or even beyond based on any type of violent price movement in the underlying futures contract. When you buy crude oil options, if you choose a strike price that’s far out enough (meaning way above where the market is currently trading), you can pick them up for as little as 1 point ($10.00) apiece. Now I’m not going to give you a “pipe dream” scenario for these options, because many times they will expire worthless, but if you can catch the right option at the right time, just before a huge upswing in price (such as what happens in the more seasonal commodities like the Grains), you can really come out with an amazing return on investment, many times into the over-1,000% range.

And why is this possible? Well, remember—that option, although it may be cheap (and not all options are cheap, believe me—I’m just talking about the way-out-of-the-money options), it still represents one crude oil futures contract, which means 1,000 barrels of crude. If you think about it, if crude was trading for $80.00 a barrel today, that would mean that your $10.00 or $20.00 option could be controlling something worth $80,000. That’s some serious leverage. So then, if the price of crude futures moves up dramatically, your option is now worth WAY more than what you paid, because its movements are based on the “Big Daddy”—the actual futures contract, not the option itself. In the early 2000’s I remember a guy that used to show up in a lot of the trading forums that I frequent, and he kept talking about how he was buying crude call options for only $10.00 apiece—these were the calls that were WAYYYY out-of-the-money at the time. They had strike prices ranging from $40.00 to $50.00. Now at the time, crude was only trading for about $15.00 to $20.00 a barrel, so these options with the high strikes were mega-cheap. But then, crude started shooting to the moon, and I’m sure the value of his call options did the same. The funny thing is, after that major move, I don’t remember hearing from that guy again. He probably bought an island somewhere from his option profits. Anyway, didn’t mean to get off on that personal story, and I know that I didn’t even come close to giving you all of the extensive information that’s available out there about trading crude oil options, but I hope you have at least a better understanding about why they can be powerful financial instruments.