Profiting with commodity ETFs

If you’re interested in energy market exposure without paying full price for energy stocks or having the unlimited risk that’s associated with buying or selling energy futures, then consider a little-used options-trading strategy. It allows you to buy a stock or exchange-traded fund (ETF) at more than half-off, reduces risk by 50% or more, offers a higher return on your investment dollars and has nearly point-for-point movement with the market.

With the options-trading technique of buying deep-in-the-money (DITM) call options, you can slash your risk and investment by more than half, while getting all the same benefits and movement that you would if you owned the stock or ETF outright. When you buy a DITM call option, you’re buying the option as a substitute for the stock.

As a call option buyer, you have the right to take possession of the stock sometime in the future at a pre-determined price level as long as it’s profitable for you to do so. In exchange for this right, you pay a small sum of money up front (considerably less than what it would cost to buy the stock outright) to the option seller. If the market doesn’t move in your favor by expiration time, you’re under no obligation to exercise the option, in which case it will just expire worthless. Why is it called “deep-in-the-money”? Because the strike price of the call option is well below the current price of the chosen stock or ETF.

To use this option strategy, you first need a stock or ETF that has available options. In the energy sector, we can consider the U.S. Oil ETF, or USO. The USO is an ETF that aims to mimic the movements of the spot price of West Texas Intermediate (WTI) light, sweet crude oil. The fund achieves this primarily by investing in futures and options contracts that trade on the New York Mercantile Exchange (Nymex). This is one of the purest ways to expose yourself to the oil market without having to invest in crude oil futures contracts.

You also can invest in oil company stock options, but these will not move in tandem with the spot price of crude oil. Stocks represent publicly traded companies and have all the risks associated with them (analyst recommendations, earnings reports, boardroom shenanigans, etc.). Those reasons alone can move a stock in a much

different direction than anticipated. For a position that truly reflects the movements of the spot oil market, the USO is the ticket.

CHOOSING THE OPTION

We first need to look at an option chain for USO that gives all the available options. In addition, we need to pick an option expiration period that will determine our holding time. If you are interested in investing in the market for a long period, choose the option with the longest expiration date. Some option contracts are available for almost three years into the future (see “Long-dated trade,” below).

Although the absolute price for each security, the ETF and the futures, has about an $18 spread between them, the main point is that the movements mimic each other precisely. This provides the confidence that whichever call option we choose will follow the path of the crude oil futures market.

“Chained to gain” (below) shows the option chain for the January 2008 expiration period. These are the longest-dated options that are currently available for trading. As of this writing, these options have about seven months before expiration.

Obviously, there are several options to choose from. Selecting the right one is critical to the ultimate success of this strategy. The key to picking the ultimate DITM call is to select the deepest in-the-money option listed by the exchange that has at least a 90 or greater delta.

Delta is one of the so-called Greek measures derived from options-pricing formulas. For the purposes of this strategy, delta is a percentage number that tells us how much the option price should change in relationship to a $1 price change in the underlying ETF. For example, an option with a 90 delta will see its price move up

or down approximately 90¢ with a corresponding $1 move higher or lower in the stock.

From the chain shown in “Chained to gain,” we see the last price for USO was $54.68. The middle column lists some of the available strike prices for call options that we can buy. Because we want a high delta, we can either choose the lowest-listed strike, which is the $40 call option with a 96 delta, or we can choose the $43 call option, which has a 91 delta. Going with the philosophy that we want the deepest in-the-money option, let’s concentrate on the $40 call for our example.

APPLYING THE STRATEGY

When we buy the $40 call option, we acquire the right to buy the USO at $40 per share at anytime until expiration day in January 2008. Of course, with the USO currently at $54.68, we have to pay a premium for the option.

Splitting the bid/ask of the $40 call option, we get a theoretical buy price of $16.10 per option. Because each option represents 100 shares, the one call option would cost $1,610. That’s more than 70% less than the retail price of buying 100 shares of the USO outright for $5,468.

To fully appreciate the value of buying the DITM option, consider how the option will respond to any corresponding move by the USO itself. This is where the 96 delta demonstrates its value (see the first chart in “Calculated value,” below).

As shown in the graphic, inputs are placed in the left-hand side and option prices and Greeks are returned on the right-hand side. With 193 days before option expiration and the USO at $54.68, the $40 call will cost roughly $16.10 per option (just like the option chain shows). You can also see the calculator has the delta at just a slightly lower number at 0.9498. Sometimes, depending on which model is used, the numbers can differ slightly.

In the second chart in “Calculated value,” the price of the USO is increased by $1 to $55.68 (see input section), all else equal. The $40 call now has a value of roughly $17.05, which is 95¢ higher than the purchase price of $16.10. Delta is working

exactly as it should. The price of the $40 call moved up in tandem with the stock.

So, for $3,858 less ($5,468 minus $1,610 equals $3,858), we got ourselves a great call option that banks nearly as much dollar profit as the outright position itself. The other benefit is that as an option buyer, the maximum loss can never be more than what you paid for the option. That means the total risk is 70% less as well. If the USO fell to zero, we’d only lose $1,610.

GETTING OUT

Because we purchased the $40 call for $16.10, the true breakeven price is $56.10. We calculate the breakeven by adding the option price of $16.10 to the strike price of $40. If we held this option until expiration, we have three choices:

1. Sell the option for the prevailing rate and buy another long-term call option. This is called rolling your options and will keep your initial cash outlay small.

2. Exercise the option and turn it into actual shares of USO. If choosing this method, you must come up with the cash balance to pay for the shares. This would be $4,000 for every option purchased.

3. If USO is trading below $40 at time of expiration, you will just let your option expire worthless and take the full $1,610 loss.

Considering return on investment, assume that our directional assessment was right and USO went up to $65 per share by January 2008. For cash shareholders that would be a $10.32 profit per share and an 18.9% return ($10.32/$54.68). For call option holders, however, we’d earn $8.90 profit per call option and a 55.3% return on investment ($8.90/$16.10).

The benefits of the DITM strategy are plentiful and sound. There’s no need to spend full price on 100 shares of stock when you can buy a DITM call option and reduce your investment and risk by upward of 70%, especially when capital otherwise invested in the full cash position can instead be put in Treasury bills for some guaranteed income. As a rule of thumb, stick with options that have at least a 90 or greater delta. Although the breakeven price might be slightly higher than where the stock is currently trading, the trade-offs are well worth it.

Lee Lowell is editor of The Tripple Zone Profit Trader (www.mtvernonresearch.com), author of Get Rich With Options: Four Winning Strategies Straight From the Exchange Floor and a former Nymex options market maker. He can be reached at editor@mtvernonresearch.com.

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