Oil’s Next Move Might Be Sideways
Oil prices have been locked in a trading range for some time. There are a number of reasons for this but it all comes down to the fact that supply and demand are close to being in balance. There are, however, some shifts between supply and demand that drive prices in the short run.
In the past few weeks, we have seen weather create concerns and actual problems with supply. The hurricanes in the Gulf of Mexico disrupted production for a time. Damage to the infrastructure on land, especially in Texas, also disrupted the supply for a brief period.
These were short term factors that were quickly reversed. And, they were not significant enough to change the long term price trend of the commodity.
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Oil prices have been in a relatively narrow range for almost two years now. The short term picture is the same, even with the weather induced volatility.
Oil prices have been within an $8 range for the past six months. For most of that time, they have been in an even narrower range, trading between about $48 and $52.
It’s likely this range will hold for at least the next few weeks, with price potentially falling as the market returns to normal.
The Short Term Outlook Is For Little to Change
One analyst believes the recent price action has been largely an overreaction. Traders noticed that after Hurricane Harvey, refinery activity along the Gulf of Mexico, where many refineries are located, fell off. Much of that was due to preventive measures. Companies will take refineries down as bad weather approaches to reduce the risk of a significant accident and environmental damage.
Because steps were taken to minimize risks in advance, those refiners are coming back online quickly and resuming production. There is still some damage for companies to contend with, including damaged storage containers in the Caribbean but companies are quickly recovering here as well.
As concerns about damaged infrastructure fade, traders will resume looking solely at supply and demand ad here the numbers support a slightly lower price.
Some analysts are noting that we are close to having a “supply glut.” According to the US Energy Information Administration, the latest oil inventory report shows that about 462 million barrels of oil are available. This is much higher than the five-year average of about 379 million barrels of supply.
Based on these numbers, a selloff in oil is possible. The bottom of the trading range is a likely support area. Traders hoping to benefit from this market should consider strategies that make money in trading ranges rather than using trend following strategies.
A Short Term Strategy For Trading the Oil Market
Traders can gain direct exposure to crude oil through the futures market. However, futures carry high risks along with the potential for significant rewards. While they may be suitable for many investors, many individual investors do not have an account registered for futures trading.
It is possible to obtain indirect exposure to oil prices by owning energy companies. This could be best for investors with a long time horizon since it could take years for the value of the underlying company to be realized.
Exchange traded funds (ETFs) are also available to obtain exposure to the price of oil. This could be the most direct way for many individual investors to access the market. ETFs trade like stocks and have risk and reward characteristics that are similar to stocks.
One ETF that tracks oil is ProShares Ultra Bloomberg Crude Oil (NYSE: UCO). There are options available on this ETF and that means we can trade flexible strategies in line with our market outlook and risk profile.
UCO is a leveraged ETF. Leveraged ETFs are designed to make large moves. That means the risk of owning the ETF directly can be quite high. Using options, instead of directly owning the ETF, can help reduce the risk and in some cases, limit the risk to a predefined amount.
For oil, and the ETF UCO, strategies should be focused on trading ranges. One options strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.
To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.
In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.
The risks and potential rewards of the strategy are shown in the following diagram.
Source: The Options Industry Council
The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.
Opening an Iron Condor in ProShares Ultra Bloomberg Crude Oil
For UCO, the trade can be opened using the following four options contracts:
As you see, all of the options expire on the same day, Friday, October 20.
The difference in the exercise prices of the calls or puts is equal to $1.00. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $100 less the premium received when the trade was opened.
Selling the options will generate $0.65 in income ($0.40 from the call and $0.25 from the put). Buying the options will cost $0.25 ($0.15 for the call and $0.10 for the put). This means opening the trade will result in a credit of $0.40, or $40 for each contract since each contract covers 100 shares.
The maximum risk on the trade is equal to the difference in strike prices ($1.00) minus the premium received ($0.40). This is equal to $0.60, or $60 since each contract covers 100 shares. Most brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $60 in capital.
The maximum gain on the trade is the amount of premium received when the trade is opened. In this case, that is $0.40, or $40 per contract.
The potential reward on the trade ($40) is 67% of the amount risked, a high potential return on investment. The trade will be open for about one week. If a trade like this is entered every month, a small trader could quickly increase the amount of capital in their trading account.
The iron condor is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that should be lower than owning the stock.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.