Daily Stock Market Equity and Options Trading Commentary

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Wednesday, September 9, 2009

Still Time to Buy Black Gold? Using Option Spreads to Capture a Crude Move

As I have blogged about for quite a while, I believe the price of oil will continue to increase as the dollar gets weaker. As the dollar showed signs of weakness Tuesday, October light sweet crude oil contracts blew past the $70 per barrel mark to close at $71.10. As long as the dollar continues to get weaker, I will continue to hold and accumulate commodity as well as oil & gas service ETF's, particularly USO and UCO. From the Google chart below, we can see the correlation between the PowerShares DB US Dollar Index Bullish (UUP), and the United Stated Oil Fund (USO) since March 9, 2009.

Over the past 6 months, the two have a negative relationship; as the Bullish Dollar ETF became weaker (weakness in the dollar) the United States Oil Fund increased. Although the weak dollar story may not be the only reason oil has risen over the past 6 months, I believe it is enough to keep oil at these levels [if not $75-$80 a barrel] until late fall.

With fuel inventories near a 30 year high, what else could be keeping oil at these levels? According to Goldman Sachs, Crude Oil could strike $85 a barrel by the end of 2009 on increased demand in the coming months, but many have criticized this figure. However, I think $85 a barrel oil isn't unrealistic if the economy starts to show signs of recovery and inventories start to diminish. But mainly I see the dollar getting weaker in the months to come causing oil to move even higher. So on with the trade...

I was fortunate to sell my shares of the Proshares Ultra Crude Oil ETF (UCO) just above 13 a share on August 21 [August options expiration]. I was looking for a re-entry point, and as crude sold off on the morning of September 4, I decided to get long by purchasing the UCO September 11 strike Call Options with very limited risk. I was able to purchase the contracts for $50 a piece and planned on holding them until the September options expiration. However as crude traded higher Tuesday, I decided to turn half of my contracts into vertical call spreads, selling the UCO September 12 strike Call Options against them. I was able to receive all of my money back as I sold the contracts for $50 a piece. I looked at writing my remaining contracts out for the September 13 strike call option, but I decided to wait, as I am very bearish on the Dollar.

Bullish Trade to Ponder: Using a much less risky ETF, the United States Oil Fund (USO), I thought it may be worth looking at opening an option spread for the month of October. With the USO approaching 37 per share, I thought of opening what I call a half-in/half-out option spread. I call it this because in this case the spread is for 2 points, I would buy a call 1 point in the money and sell a call 1 point out of the money. This could be done if and when the USO crosses 37 a share. At that moment I would purchase the October 36 strike call and sell the October 38 strike call. At current prices (USO close at 36.94), this would cost $95 per option contract.

If crude oil continues to rise through October as I expect, and the USO is at or above 38 per share at October options expiration, this position would return 110%. The cost of the contract is $95 which means this spread is profitable as long as the USO is at or above 36.95 at October options expiration. I will be looking at opening this trade after crude inventories are released Wednesday, as levels of implied volatility may decrease causing the contracts to become a bit cheaper. If crude happens to sell off on the inventory release and the USO nears 36 a share, I am still bullish, and may look at opening spreads using the October 35 and 37 call options.

The ideas outlined above involve the use of stock options. To learn more about option spreads, risks, pricing, calculations, other strategies, and options in general click here.

These are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

The reason option volumes have surged in the last 5 years is because they are a great way to hedge your portfolio as well as create income off of your shares (see option volume chart).

Disclosure: Long USO, September 11 UCO Calls, Short September 12 UCO Calls

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