Bullish crude call spreads

April 4, 2018 02:00 PM

In  2007 crude oil began the year priced at $60 per barrel. By July 11, 2008, it rose to $145.66, which was a nearly 150% increase, and a 31.6% increase in a little more than half a year. Southwest Airlines (LUV) was the only airline that hedged its largest variable cost. Southwest was paying $30 per barrel less than most of its competitors. In a little over five months later, on Dec. 26, WTI had dropped all the way down to $32.34. That’s a 77.8% decrease.

The Great Recession created deflation, knocking down prices everywhere. If you traded options from the net long side in 2008, you had a very good year. The moves were much greater than the premium that you had to pay for crude options, which allowed you to participate in the movement. It was an equally great year for hedgers as they were able to ride out the volatility relatively unscathed with the protective use of options. 

By June 11, 2009, crude had more than doubled to $72.68, and by March 2011 it crossed the $100 per barrel barrier. For the next three years, WTI spent most of its time between $85 and $105. Crude began a steady sell-off in mid-2014 that systematically took out one support level after another. This was not due to macroeconomic factors this time around. A new technology hit the scene and supplies of crude suddenly became abundant. 

The new technology was horizontal fracking. Previously, unattainable supplies were now dumped onto the market. OPEC could no longer hold its supply off the market and expect a sharp price rise. Instead, it chose to continue to pump to drive higher-cost producers out.  As prices dropped, countries heavily reliant on sales of crude, like Russia, Venezuela and Nigeria, were dumping more oil onto the market as prices dropped. Those countries and independent frackers in debt needed cash. Prices bottomed out at $26.21 on Feb. 11, 2016. This led to a wave of bankruptcies amongst frackers. Within a couple of months prices were back in the $40s.

During the next 18 months, crude traded in a range from $40 to $55. On the last day of 2017, the $60 barrier was broken and rose to a high of $66.14 on Jan. 26, 2018. The increase in prices was due less to a matter of shortages than the easy money policies of the Federal Reserve, a declining dollar and growing demand. The asset bubble that propelled prices upward in stocks and real estate was taking crude along for the ride. The anticipated rise in interest rates sent stocks reeling and a pullback in crude prices as well.

The WTI Nymex futures are in backwardation with the March 2018 futures settling at $59.19 and the May 2019 settling at $54.58. Backwardation means that the nearer-term futures are trading higher than the further out futures. The current expectation is that prices will decline over time.  

The May futures settled at $58.50. The May 505 puts settled at 0.48. The May 665 calls 0.35. Because the calls and puts are equidistant from where the futures are currently trading, this means that the options are positively skewed to the downside and negatively skewed to the upside. This means that options traders expect that downward moves will occur more rapidly than upside moves. This is not a particularly sharp skew, however. The skew is much sharper in stock indices and Treasuries. The next thing to look at is the at-the-money straddle. The May 585 calls and puts are both trading at 2.45. This means that the expected range between Feb. 13 and April 18 is $53.60 to $63.40. 

If you’re bullish you could buy the May 610 calls for 1.53. The breakeven point for this trade is $62.53. The futures need to climb $3.68 just for you to break even. Your max loss is 1.53. Your upside is unlimited. You can sell the May 625 calls at 1.05. That cuts your max loss to 0.48 and your breakeven point to $61.48. Your upside is no longer unlimited. The max value of the spread is 1.50 so your max profit is 1.07. You can sell the May 625-645 call spread for 0.44. That means that your max loss to the downside is now only 0.04. Because you have sold a two-point vertical spread, your max loss above 64.50 is 0.54.   

About the Author

Dan Keegan is an experienced options instructor and founder of the options education site optionthinker.