Oil Futures Options - How to Trade Options

Follow the Price of Oil and Profit with Oil Futures Options

The existence of unique financial instruments known as oil futures options allow many investors to turn this precious resource into an investment that brings a return without all of the risk normally found in the futures market. The distinction between futures and options are at the heart of this opportunity.

Oil futures options differ from regular oil futures primarily because of the clause in the options contract which gives the holder the right but not the obligation, to buy or sell a certain quantity of oil at a set time in the future. This provides the owner of an option contract with some insurance against unforeseen price volatility.

In any case, the owner of a ‘long’ options contract can only lose up to a maximum of the amount debited upon entering the trade. But with a futures contract, the losses are potentially much greater. Also, options holders never have to worry about a margin call. However, these advantages are no longer available once the market closes on the expiration date of the contract.

Options are divided into two categories – call options and put options. Bullish traders, who believe that oil prices are going to rise, will buy call options. These allow the trader to buy oil at a fixed price, up to an agreed expiration date. The idea is, that between the option purchase date and its expiration, the market price of oil will be higher than the option exercise price. Put options allow the trader to sell the contracts at a fixed price, even if the market value of the oil has dropped below that price.

Oil Futures Options Vs. Regular Oil Futures

These options are not without risk, or they would not be so lucrative. They offer the ability to limit loss and give the buyer some additional leverage. However, they can also expire as worthless and lose the buyer’s entire investment.

In addition to this leverage and limitation against losses, oil futures options also offer a lot of flexibility in your investment. They are widely used in combination with futures contracts to minimize loss and maximize gain. They also provide an excellent sense of insurance during times of high volatility.

However, these options also suffer from time decay. The value of an options contract decreases as time passes. Since you can choose to switch from buying options to selling options, this risk is somewhat lessened.

Oil futures options are traded on the New York Mercantile Exchange (NYMEX) where one options contract covers 1,000 barrels of oil and their prices are quoted in dollars and cents per barrel. Since one barrel of oil is 42 gallons, one option contract covers 42,000 gallons of oil.

Oil futures and their options are quoted on the exchange as:
1. NYMEX Light Sweet Crude
2. NYMEX Brent Crude

What Affects the Price of Oil

Oil is a commodity in huge demand, not only for machinery but also for heating. Consequently, the price of heating oil generally rises during the northern hemisphere winter. But the price of crude oil is also affected by a number of geopolitical factors such as war in the Middle East, recessions and natural disasters such as hurricanes, earthquakes and the like. When the price of oil becomes volatile due to an uncertain political climate, option strategies such as straddles and strangles can really bring home the bacon. Keeping abreast of the factors that contribute to fluctuating oil prices really pays.

Once you understand the relationship between oil futures and their associated options contracts, you can employ option trading strategies that either focuses exclusively on only options contracts … OR on a combination of holding futures contracts and options for the same commodity – in which you can take either a “buy” or “sell” position.