There are four main ways to gain exposure to oil as an investment. You can buy oil directly (probably not practical for you); you can buy stock in companies that have something to do with oil; you can purchase oil futures contracts; or you can buy oil options.
For many traders, buying options is the most practical and one of the safest ways to gain exposure to oil and trade this valuable commodity without having to actually take delivery of oil or deal with only indirect exposure through an oil company. Here, we’ll talk about oil options and discuss how you can leverage these instruments for profit in a fast-moving market.
A Brief Review of Options
First, we’ll briefly cover options and how they differ from other assets.
When you purchase shares of a stock, you are immediately taking ownership of a piece of a company and are exchanging money for your new possessions. When you purchase futures, you are committing yourself to fulfilling the terms of a contract that calls for a certain asset changing hands from the seller to you at a certain date in the future, for a certain price.
When you buy options, you are buying the right but not the obligation to purchase a particular asset. Stock options, for example, give you the right to buy stock for a certain price by the time the option expires (the expiry). You don’t have to, though, especially if making that trade would cause you to lose money.
For this right, you pay a premium to the option seller. This money is lost to you, no matter what. The good news about that is you can cut your losses to just the premium if the market heads south and the price isn’t advantageous to you.
Oil options are a bit more complicated than stock options, though.
Oil Options: What They Represent
It’s not quite the same with an oil option as it is with a stock option. You aren’t buying the right to purchase oil; rather, you are buying the right to purchase an oil futures contract. A futures contract, remember, is an obligation to purchase oil at a future date for a future price. The flexibility oil options give you is the ability to forgo purchasing that contract if the market doesn’t do what you want it to do by the time the option expires.
So, purchasing a call option in oil means you are buying the right to pick up an oil futures contract that is long in the market. In other words, you’d profit if the price of oil increases. Purchasing a put option in oil means you are buying the right to pick up an oil futures contract that is short in the market, which would mean you’d profit if the price of oil falls between now and then.
Advantages of Oil Options Versus Futures
Of the three main ways people gain exposure to oil (stocks, options, and futures), options offer several advantages, particularly against futures.
For starters, you can cut losses much more effectively with options than futures. If you buy a futures contract and you take a hit, you could be in for steep losses. With an option, though, you are only out your premium because you don’t have to exercise the option; you can simply let it expire. Similarly, with a stock, you are on the hook for any losses incurred after you buy the stock.
Options are also more liquid than either other alternative. In other words, they’re easier to buy and sell. It’s not nearly as daunting a proposition to sell an underperforming option than an underperforming futures contract or stock, simply because other investors would have more flexibility if they purchased the option from you.
Finally, options give you more leverage than futures. Futures are already significantly leveraged; for the price of one contract, you can control 1,000 barrels of oil that have a market value of close to $100,000 (depending on the price of oil).
Since you’re controlling a futures contract with your option, you can exercise even more leverage because you’re only paying a premium for the ability to leverage a large quantity of oil – and only if doing so would turn a profit.
Disadvantages of Oil Options
There are disadvantages, naturally. Options are subject to a phenomenon called time decay. In other words, the longer you hold an option, the less valuable it becomes. Options have value because of the flexibility they offer traders. With each day that passes, the flexibility of your option decreases.
Think of it like this. If you have an option that is based on oil being, say, $90 a barrel by December 31st, and it’s December 30th, you know that whatever the price of oil is today is probably what it is going to be tomorrow on the 31st. So, it’d be hard to find someone to buy your option if the price of oil were, say, $89. There’s just not enough time for the price of oil to rise above $90 a barrel to make it worth someone’s while to take you up on your offer.
Also, keep in mind that an oil option controls an oil future – which means you are buying futures in one of the world’s most volatile and sensitive commodities. Speculation in particular has a big impact on prices and is virtually impossible to predict reliably – in part thanks to the relative ease of use of oil options and oil futures, ironically.
Should you decide you want to buy oil options, you can do so on the world’s two major futures exchanges: NYMEX and the Intercontinental Exchange (ICE). You have to find a broker who has access to these exchanges and offers the options you want to purchase.