Positioning for an oil surge with options

January 9, 2014 04:56 AM

With crude oil (NYMEX:CLG14) trading at its lowest levels since early December, traders are beginning to position themselves for 2014. Recent declines in oil prices were extended in yesterday’s trading session after the release of inventory numbers that showed a greater than expected increase in supplies as demand continued to slide. Crude managed to trade above $100 in December before falling to below $92.50. Increased production also adds to the downward pressure on crude.

While any rally in the second half of December was met with active selling, bulls still believe that 2014 will be a good year for oil and prices will be bolstered by increased demand in countries like China.

With crude selling off five of the six 2014 trading sessions, the risk is clearly to the downside. Traders looking to speculate on a rebound in crude prices would be required to take on a high level of risk if they chose to trade the underlying. Options on futures can offer a trader a clearly defined risk and reward profile and can help a trader stay in a trade through volatile markets.

The first step to setting up an options trade is to calculate price targets. Using the options market and implied volatility will allow for the most accurate estimates of expected moves in the underlying. With the options market implying a move of $5.60 by April expiration an upside target of $98.10. With this target, a trade can be set up on that level.

Trade: Buying the CL Apr 97-98 Call Spread for $0.25
Risk: $250 per 1 lot
Reward: $750 per 1 lot
Breakeven: $97.25

This trade sets up for maximum profitability if crude is trading above $98 on April expiration. This trade also sets up for a 3-to-1 reward-to-risk ratio and is a much more capital efficient way to trade potential upside in crude.

About the Author

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.