Building a hedged oil position

The recent bombing of a Syrian air facility by the United States sent a little jolt into the crude oil market. While Syria is not a big oil producer, it is in the same neighborhood of the largest concentration of oil production in the world. At the onset of the Gulf War in the summer of 1990 the WTI January futures contract rose from $18.40 (July 9) to $38.10 by Oct. 10, 1990. The recent 2% bump in crude looks paltry by comparison. The advent of fracking means that the political machinations in the Mideast, Nigeria, Russia and Venezuela cause the earth to shake a little less violently. But if bombs start flying back and forth then you can expect the energy sector to heat up considerably. 

How can your average investor or trader best approach the situation? You can trade the physical, the futures market, an exchange-traded fund (ETF) or options on any of the above. Let’s first look at the ETF alternative. The two most successful commodity ETFs are GLD and SLV.  GLD and SLV trade 12.1 million and 10.7 million shares per day, respectively.  They both have robust open interest in options. Both derive their value from their large physical holdings in the commodity. The storage costs involved are minimal. That makes it easy to track the spot price for gold and silver. That is not the case for energy and agricultural products. The sheer size and cost of security for the stored products is much greater. That is why those ETFs consist mostly of futures contracts. In the case of crude ETFs: USO, UCO and OIL are the biggest. USO averages 18 million shares daily while UCO and OIL check in at 4.7 million  and 1.6 million, respectively. The listed options open interest and volume in USO dwarfs that of either UCO or OIL. If you’re going the ETF route USO is the most liquid. 

Trading in the physical product directly would be too costly for all but the most well-heeled traders, so that brings us to the third alternative: futures. If the ETF is backed by futures contracts, then why not go directly to the futures?

The other advantage is the margin: 50% on the ETF versus around 7% for futures. Your dollar can be stretched a lot further as long as things are moving in your direction. If you buy one futures contract at $52.95 you come up with $3,700 for a value of $52,950.

If the futures rise to 56 you make $3,050 on a $3,700 investment. 

You can buy a July 530 call for $2.57 ($2,570). If the futures settles at 56 then you make $430 on a $2,570 investment. Nice return, but it can’t match the futures return. Then again your maximum investment is $2,570. If the futures happens to head south then you have to keep throwing money at it. A gap move down can wipe out your account. You can cut your maximum loss on the option trade by selling a 560 call for $1.30. Your maximum loss is now less than half at $1,270. With the naked long call you have unlimited upside profits above $55.57. By selling the 560 calls you have limited your maximum profit to $1,730 (see “A crude play, above”). You have given somebody else the opportunity to make unlimited profits above $57.30. You give up the possibility of a home run with the naked long call for the possibility of doubling the size of your position.

By taking a 10-lot position, if the futures head south you can sell three of your long 530 calls and buy three 590 calls to keep your numbers even. Your maximum loss is now less. You need to hedge dynamically if you expect to make money trading. Things usually don’t go exactly as planned.