Daily Stock Market Equity and Options Trading Commentary

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Tuesday, May 12, 2009

Time to Get Long Black Gold? How Option Spreads Can Pay Off

Despite Monday's stock market sell-off it looks as if crude oil hung in there quite well. Crude closed Monday at $58 and change. Big oil names such as Chevron (CVX), Exxon (XOM), ConocoPhillips (COP), Frontline (FRO), Nordic American Tanker (NAT), and Valero (VLO) sold off far worse than crude oil.

The overall market and crude have traded similarly over the last month as the Google chart shows below.

Crude may be recovering due to speculation that the economy is getting better, or possibly due to fears of inflation and a weak dollar. Whatever the reason, crude is trending up. I certainly don't think we'll see $140 crude but I believe $70-$80 crude isn't out of the picture by peak driving season. The current Bull to Bear Ratio (as defined here) on the USO is 9:2 is up from 8:3 last week.

I have two Gas Guzzling SUVs, therefore I like to hedge myself whenever possible. A way to hedge my expensive driving habit, is to profit off of crude oil increasing. Since I am speculating, I like to play vertical call option spreads, ones with big upside and minimal downside. Some option spreads I am playing with involve two crude oil ETFs, the USO and the UCO (double leveraged crude oil ETF - dangerous!). As we can see from last season, Crude peaked in July, therefore I speculated with the option contracts for the July expiration.

Yesterday I bought the July 35 USO contract and sold the July 40 USO contract for a difference of $90 per contract. If the USO gets above $40 by July's option expiration I will make $410 per contract ($500-$90). Since my cost is only $90 per contract, In order to break even I need the USO to get to $35.90. I believe this is feasible, as it is less than 12% higher.

The other call spread I opened yesterday was for the UCO. I bought the July 11 for $85 per contract and sold the July 15 for $30. The downside involved in this contract is $55 per contract with an opportunity to get $400 per contract (net of $345 or 600%+).

There are many other crude ETFs that are plenty volatile to fetch nice option premiums on, these are just two. I used this strategy last summer as the price of crude kept rising, and it paid off BIG!

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