By Brian Benson, On Course with Options
Why Trade Oil?
The West Texas Intermediate (WTI) oil futures contract (ticker CL) represents a huge market with great liquidity. Liquidity is an important consideration when picking a market to trade because it allows traders to easily enter and exit trades with minimal slippage. Slippage refers to losses due to wide bid/ask spreads and price gaps that can occur when markets are thinly traded.
In terms of volume and participation, WTI (CL) is the most liquid commodity market. The average daily volume in oil futures is currently about 1.35 million contracts per day. That represents upwards of $70 billion dollars of WTI oil notional value being bought and sold daily.
Similar to many optionable stocks, there is an active options market that uses the WTI (CL) contract as the underlying. The options market on the WTI (CL) contract tends to be very wide and deep. Puts and calls trade with numerous expiration cycles and with generally very good liquidity over a wide range of strike prices.
Like stocks, the price of oil can be driven largely by the macro economic outlook. But, oil is often not well correlated with the stock market. There certainly are times of divergence, and that can lend another way to diversify our overall risk by trading an uncorrelated asset class.
As a commodity, the price of oil is ultimately driven by basic supply and demand. The are no earnings surprises, sudden executive departures, mergers, takeovers, etc. like that which can happen with publicly traded companies.
Oil can be a volatile product, so option premiums tend to be rich. While option premium is not always overpriced, there are often long stretches of time when it remains overpriced.
Perhaps the biggest reason to trade oil is the leverage available both on the underlying futures contract and the options (puts and calls) that are traded on those contracts.
Futures and options on futures are a way to trade oil rather directly and with high leverage in a SPAN margin account. For example, a single WTI contract that controls 1,000 barrels of oil at $55 per barrel has a notional value of $55,000. Depending on your broker, you may be able to trade that contract for about a $5,500 reduction in buying power, or roughly 10 percent of the notional value. Similar leverage is applicable to options on those futures.
Why Sell Oil Options Rather Than Buy Them?
I am primarily an option premium seller on oil for the same reasons I am primarily an option seller with equities.
I prefer to be an option seller where I can improve my probability of having a profitable trade in exchange for the limited upside of the premium collected. Option selling fits well with my lifestyle where it is usually (but not always) much less stressful than buying options, and I don’t have to be at my trading desk as much.
How to Sell Oil Option Premium
For traders familiar with strategies for selling options on stocks, the same strategies can be applied to oil. Both defined risk and undefined risk trades are possible. You can sell naked options, straddles, strangles, ratio spreads, verticals, etc.
As an option seller, I want to sell premium when it’s relatively expensive and cover those positions when premium is cheaper. Similar to the VIX volatility index for the S&P 500, there is a specific volatility index for oil known as the OVX. The OVX is a great tool for analyzing what is happening with volatility in oil and how relatively cheap or expensive options on oil are.
There is no asset class or strategy that works well in all markets or is “fool-proof.” Like any other asset class and trading strategy, there are risks to trading oil.
In a futures account with SPAN margin, you have the risk of margin expansion. Although your initial margin requirement may have been relatively small, your maintenance margin can increase dramatically when there is move against your position. If the move is adverse and sustained enough, you can find yourself forced to sell out of losing positions at terrible prices and perhaps at the worst possible time. For that reason, you should keep plenty of uncommitted margin cash on hand and be very conservative in the amount of margin you use.
Oil does carry geopolitical risk. For example, in September 2019, Saudi Arabia’s oil infrastructure was targeted in a missile attack that dramatically took half of their daily production offline — roughly 5 percent of world oil production. Events like this can understandably cause sharp and sudden moves in the price of oil.
How to Get Started
You do not have to be an expert on the oil industry to trade it as an asset class.
For starters, you do need to be well aware of the contract specifications unique to oil futures.
Like many other futures contracts, oil trades nearly 24 hours a day. The CME oil contract trading hours are Sunday – Friday 6 pm- 5 pm (5 pm- 4 pm CT) with a 60-minute break each day beginning at 5 pm (4 pm CT).
You should familiarize yourself with regular events (i.e. OPEC meetings) and reports that influence perceptions of oil supply and demand.
On a weekly basis there is the American Petroleum Industry (API) Weekly Statistical Bulletin (WSB) which normally comes out on Tuesdays at 4:30 pm Eastern. Often a little more market moving is the Energy Information Agency’s (EIA) Weekly Petroleum Status Report which is normally released on Wednesdays at 10:30 am Eastern. Both of these weekly reports can be delayed by holiday schedules.
In addition to API and EIA reports, many traders look to the Commitment of Traders (CoT) report published by the U.S. Commodity Futures Trading Commission (CTFC).
You can learn all that you need to know on your own — but that can be the hard way. You’ll likely learn a lot faster, pick up on the many nuances of trading oil and avoid some potentially serious pitfalls by learning from an experienced oil trader who can coach you.
CME WTI (CL) Oil Contract Specifications
Disclaimer: The author is not a financial advisor and the following should not be taken as financial advice. This is by no means a complete discussion of the pros and cons of trading and/or investing. Please consult your own qualified advisors to determine what is appropriate and best suited to your specific investment objectives and risk tolerance.