The mean, inflation adjusted world price of oil since 1970 is $35, while the median is $30. The current spot price of oil is $86.15. Reversion to the norm is one of the basic tenets of trading. Can an argument be made that oil has plenty of room to the upside? In the summer of 2008, irrational exuberance, speculators gone wild or, most likely, a record low dollar and active Fed led the price of oil to nearly $150. If you take a longer-term view over the last 140 years, the mean is $23 and the median is $17. This suggests that the average price of oil is in an upward trend. Countries like China, India and Brazil are now major commodity consumers, whereas 30 years ago they were mired in poverty. Currently, demand for oil seems to be outstripping supply. The normal mean and median may be higher, but by how much?
If the trader is long the July 2010 crude oil futures that are trading at $88, they could enter a stop order at $79.20 that would limit their losses. However, there are two downsides to that strategy. With numerous volatile factors including the oil spill in the Gulf and Eurozone debt issues, crude could dump for two days, taking out the stop, and then head back higher. Or, it could zoom through the stop price and not look back. Neither scenario gives much comfort.
Another option for the trader is to buy a protective put. The July $79 put could be purchased for $3.76 per barrel or $3,760 per contract. That is far more expensive than using a mere stop order. The trader, however, is still able to maintain a long futures position in crude oil if the market dips below that level briefly, while defining any possible loss.
Can this “insurance” be purchased without the cost (put premium) being so high? There is nothing that the trader can do about the put premium but they can sell some call premium against the position that will defray the overall cost of the position. When the trader sells the call, there is no upside risk to the position since the long futures position will go up in tandem with the short call position.
The July $97 calls can be sold for $2.09 per barrel or $2,090. That cuts the cost of the position down to $970, less than one-fourth, the cost of the put alone. Losses are limited to a 10% downside move. Unfortunately, profits are limited to a 10% upside move. The futures are “collared” between those two points (see “Defined risk/reward").
Since crude oil is trading far above the mean, the options on futures are negatively skewed to the upside and positively skewed to the downside. This means that the time value that is embedded in the options premium increases with lower strike options and conversely decreases with the higher strike options. What that means is that a looser collar becomes more expensive. If the trader wanted to risk a 20% downside move, while allowing the futures to appreciate 20% to the upside, it will cost $2,220. The $106 calls sell for only 65¢, while $70 puts cost $2.87.
This is a great strategy to use if the trader is already long futures. Would it be smart to establish a position like this? There is an easier way to accomplish the same goal. Instead of buying the July futures, buying the July $79 puts and selling the July $97 calls, the trader could buy the July $79 calls and sell the $97 calls against them. There are no further losses below $79 and no further gains above $97. The trader could also sell the July $97 puts, while buying the $79 puts for protection. Collaring a long futures position, buying a call vertical spread and selling a put vertical spread all benefit from an upside move and are positions where the maximum profit and loss in the position is defined. Collaring a long futures position is a method whereby the trader transforms a naked long position into a bullish vertical spread.
With crude oil pouring into the Gulf and sovereign governments on the verge of bankruptcy, it is smart to define your risk.
Dan Keegan is an options instructor and head options mentor at www.TheChicagoSchoolofTrading.com.