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How to Play Oil Prices With Options:
If you want to bet on higher oil prices, you might consider buying the ETF (Exchange Traded Fund) OIL. This is simply a measure of the price of crude oil. I don’t like to trade OIL, however, because the price is too low (under $12) to have meaningful option prices (and the options market is not very efficient which means it is hard to get decent prices because bid-ask ranges are too high).
An alternative ETF is OIH. This covers the oil service companies, like drillers and transporters. There is an extremely high correlation between the prices of OIL and OIH, and OIH has the advantage of having a higher absolute price ($35.50 at Friday’s close) and a more efficient options market (including weekly options and LEAPS).
Check out the chart for OIH for the last year:
If you had been smart (or lucky) enough to buy OIH when it rose above its 30-day moving average a year ago, you might have owned it while it rose from about $46 to about $55 when it fell below its 30-day moving average and then if you sold it short, you might make gains all the way down to $36 (you would have had to resist buying it back when it briefly moved above the moving average a few months ago).
Now OIH is well above this moving average and this might be a good time to make a bet that it will move higher going forward. If you wanted to bet that the price of oil (and OIH) will remain flat or move higher, you might consider these trades (with OIH trading at $35.50):
Buy 3 OIH Jan-16 35 calls (OIH160115C35)
Sell 3 OIH Mar-15 36 calls (OIH150320C36) for $3.05 (buying a diagonal)
Buy 1 OIH Jan-16 35 call (OIH160115C35) for $4.45
These prices are at $.05 more than the mid-point between the bid and ask prices for the option or the spread. You should be able to get those prices – be sure to enter it as a limit order because bid-ask ranges are a little high (although narrower than they are for OIL).
If you got those prices, your total investment would be $915 plus $445 plus $5 commission (Terry’s Tips commission rate at thinkorswim) for a total of $1365.
This is the risk profile graph for these positions when the March calls expire on March 20:
The graph shows that if the price of OIH ends up in a range of being flat or moving higher by $3, the portfolio should gain about $300, or about 20% for the six weeks of waiting. The nice thing about owning options is that you can make this 20% even if the ETF doesn’t go up by a penny. If you just bought OIH instead of using options, you wouldn’t make anything if the ETF didn’t move higher.
Even better, if OIH falls by a dollar, you still make a profit with the options positions. If you owned the ETF instead, you would lose money, of course.
Owning an extra uncovered long Jan-16 35 call gives you upside protection in case OIH moves dramatically higher. It also leaves room to sell another short-term call if OIH drifts lower instead of remaining flat or moving higher. Such a sale would serve to reduce or eliminate a loss if the ETF moves lower.
When the March calls expire, you would buy them back if they are in the money (i.e., the ETF is above $37) and you would sell Apr-15 calls at a strike slightly above the current ETF price. You should be able to collect a time premium of about $100 for each call you sell.
There will be 10 opportunities to sell one-month-out calls for $100 before the Jan-16 calls expire. Once you have collected $100 for each of 3 monthly calls you sell, you will have all your original investment back, and further sales are clear profit. As long as the Jan-16 calls are in the money when they are about to expire, you would collect additional money from those sales as well.
This strategy involves making trades around the third Friday of each month when the short-term short options are about to expire. That could be a pain in the neck, but to my way of thinking, it is a small price to pay for the possibility of doubling my money over the course of a year. There is a variety of other option strategies you might employ, but this one makes good sense to me.
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Any questions? I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.
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I look forward to having you on board, and to prospering with you.
Terry
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