Possibly the Smartest Money in the World Turned Bullish on Oil
Futures traders divide the money in the market into groups. Among the groups they follow are the smart money and the dumb money.
Smart money includes the producers of a commodity and the largest commercial customers. These are the individuals that have true inside knowledge. They know when supply will be disrupted for maintenance or when customers are ordering less.
Dumb money is the individual trader. In the futures market, prices can move quickly, and traders need a large cash reserve to survive sharp moves against their positions. But, individuals are often undercapitalized, and they tend to close positions in a panic.
Using this categorization, in the oil market, Saudi Arabia would have to be considered among the smartest of the smart money. And, the Saudis are bullish.
Raising Prices Shows a Strategy at Work
Reuters reported that “Asian oil traders are stumped by how Saudi Arabia derived its official selling prices (OSP) for May after the world’s top oil exporter unexpectedly raised the price for its flagship Arab Light crude sold to Asian refiners.”
The state controlled company Saudi Aramco increased Arab Light’s official selling price for May by 10 cents per barrel to a premium of $1.20 a barrel to the average of Oman and Dubai quotes. This surprised market participants who were expecting a cut of between 50 cents to 60 cents a barrel.
“This is a very unusual official selling price (OSP),” a trader with a North Asian firm said. “It’s not in line with the past method of estimating prices.”
Experts noted that Saudi Aramco typically sets the Arab Light crude price each month based on the price curve between the first-month and third-month cash Dubai prices published by S&P Global Platts.
The structure of that curve, whether it is in backwardation, when current prices are higher than later prices, or contango, when later prices are higher than current prices, set the direction and magnitude of the price change.
A contango market suggests weaker demand for oil right now while backwardation is the reverse.
Last month, the contango between the first- and third-month prices widened by 55 cents from February to March, leading to the expectations for the price cut, even as other benchmarks Brent and West Texas Intermediate remained in backwardation.
It remains to be seen if other Middle East producers Iraq, Iran and Kuwait, who use the Saudi OSPs as a reference, will follow suit when they announce their prices next week.
The moves comes as oil prices seem to be moving up.
“It’s certainly taken the market by surprise given the way the Dubai and product curves have traded of late, but we think the raise has to do with ongoing strength in light crudes and condensates which has spilled over into the naphtha markets,” Energy Aspects analyst Virendra Chauhan said.
Strength in the market could benefit companies in the sector, including Schlumberger N.V. (NYSE: SLB), a company that provides technology for reservoir characterization, drilling, production and processing to the oil and gas industry.
A Strategy to Benefit While Waiting for the News
Traders are waiting on news on oil prices. That indicates the likelihood of a relatively narrow trading range. 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 SLB
For SLB, the trade can be opened using the following four options contracts:
As you see, all of the SLB options expire on the same day, Friday, April 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 $1.20 in income ($0.40 from the call and $0.80 from the put). Buying the options will cost $0.80 ($0.40 for the call and $0.40 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. Many 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 about 67% of the amount risked, a high potential return on investment for a trade that will be open for about two weeks. If a trade like this is entered every month, a small trader could quickly increase the amount of capital in their trading account.
This trade in SLB could also be closed out early to reduce the potential risks of the trade. It could still deliver its maximum gain even if the position is closed before the expiration date of the options.
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.