Capturing oil’s downtrend with options

Since breaking the $100 level in mid-October, WTI crude oil futures (NYMEX:CLZ13) have been in a clear downtrend as prices continue to fall through key support levels. With the recent weakness in crude, traders are asking themselves just how far it can fall. There are several factors that will lead to lower crude oil prices. Over the past few years the price of crude has been propped up by geopolitical tensions, strong hurricane seasons here in the U.S. and refinery problems. Today’s geopolitical landscape is relatively stable with regards to energy and we have had a relatively mild hurricane season. The U.S. also has massively increased domestic energy production as shale fields yield record production levels.

This growth in oil production will make the U.S. the world’s top oil producer by 2015. An increase in supply is not the only factor weighing on oil prices. Slowdowns in demand account for much of the downside we have seen in oil as well. Recent studies show that Americans are not driving as much as they did before the financial crisis. This has put a damper on oil demand and also has sent gasoline prices to near 3 year lows. With crude prices continuing their fall, it is likely that traders will look for ways to get short crude in the short- to medium-term.

With price action reaching another support level around $92.00, how can a trader play further downside in crude oil?

  1. Short crude oil futures. With large tick sizes a trader would have to risk a lot using a wide stop when selling futures naked. This trade also would have the risk of blowing out a traders account.
  2. Selling shares or trading options on United States Oil Fund, LP (USO). While the USO does a good job of tracking the price of crude, it is not as efficient as other derivative products.
  3. Options on crude oil futures. This is the most risk efficient way to take a bearish view on oil prices. We will be able to set up a trade with a great return potential and a low risk setup

With the CL February at-the-money straddle trading around $5.90 and futures at $94.00 we can calculate an implied close of $87.10 for February expiration.

Trade: Buying the CL Feb 88-87 Put Spread for $0.20
Risk: $200 per 1 lot
Reward: $800 per 1 lot
Breakeven: $87.80

This trade has a great risk to reward ratio and is a very capital efficient way to speculate on a further fall in crude oil prices through February expiration.

About the Author
James Ramelli

James Ramelli is the Moderator of the Live Futures Options Trading Room at KeeneOnTheMarket.com where he actively trades futures and options on futures while educating members on strategies, setups and risk management. He has a degree in Finance with a focus in Derivatives Trading and Financial Engineering from The University of Illinois and has been trading for five years. James appears regularly on Bloomberg T.V. and BNN and writes a weekly column for Futures Magazine.

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