You Can Still Profit from the Oil-Forex Options Spread
It’s shortly before market open on Monday as I write this, and I’m watching as the second stage in a mega options spread play unfolds.
This started last week in Europe but is becoming part of the NYMEX – U.S. crude futures – landscape. For a variety of reasons, the U.S. market had not been the primary initiator, but it stands to feel the full effect of this.
“This,” by the way, is all about maximizing the return from playing crude oil prices against the dollar-euro exchange (forex) rate.
Consider both of these a store of value; a change in one is likely to be reflected in the other.
While this will impact oil prices – and, thus, is of interest to us – it is not something in which the average investor can become involved.
Yet there is a way to profit.
Options Trading Shapes the Oil Market (and Vice-Versa)
You can, of course, buy calls and puts in the options market.
The action in crude in this spread currently unfolding has been on the put side – by traders who think the price will decrease.
In layman’s terms: Most traders are betting on the price bias experiencing downward pressure for the next 10 sessions. (This is a play for the next 10 sessions only, because monthly options expire at close on the third Friday of the month.)
To participate, you need to have 100 shares to buy the put option on a crude oil exchange-traded fund (ETF).
Even if you have the 100 shares, however, don’t run right out and buy the option. Because the real money to be made here requires a spread that offsets the oil play with one in the forex trade.
More on that in a moment…
There are also a number of options being bought and sold in sequence, as well as synthetic “bridge” derivatives introduced to maximize the interplay. Not for the novice or for the investor with a weak stomach!
As I noted here briefly last week – in “Can You Spell V-O-L-A-T-I-L-I-T-Y?” from May 6 – options trading has been a major factor in the decline in oil prices (down 14.7% as of close on Friday).
While you can certainly buy basic options for just about anything traded, what these guys are doing is well beyond the ability of an individual investor. They are moving great amounts of funding into and out of two markets – simultaneously.
Here’s how it works.
Options allow you to lock in a price to either buy or sell a security before the expiration date on the option. Normally, that is the third Friday of each month.
Unlike futures contracts, the options provide the buyer the right, but not the obligation, to acquire a certain security at a certain price by a certain date.
Essentially, the idea is to buy options out of the money and sell them in the money (and selling them “deep” in the money is even better). This simply means you buy the option pricing the underlying security above the current market price (if you think it is going up)… or below (if you think it is going down).
If it turns out you are correct, you make a tidy profit. If you are wrong, you let the option expire and lose only the premium you paid for the option right.
However, what is going on now by certain market-movers is called a spread. They are buying two (or more) options simultaneously… and on different underlying commodities. One is crude oil; the other is the currency exchange rate.
Such a spread is particularly applicable to oil because its international trading is overwhelmingly denominated in dollars.
For this reason, commentators often rely on the direction of the dollar’s value against the euro for indications on the price of crude.
If the dollar’s value against the euro goes down, it takes more of them to buy the same barrel of oil. If it goes up, it takes fewer.
Of course, the declining market price for oil will be reflected as well in the forex values of the dollar. And that sets the stage for some big money folks to make even more profits off of options spreads between oil and dollar-euro rates.
Come May 23 – and the next options cycle – this will likely change. That’s because the overall dynamics in the oil market continue to show an upward pressure.
Prices will be moving up regardless of what these options traders do. They are merely playing an opportunity here to make some added profit.
Quite apart from what’s pressuring oil prices higher, the currency side of the spread is also under other pressures. Most recent is this morning’s renewed concerns over what the European Union may need to do to refinance – yet again – a worsening Greek debt problem.
I happen to be going to Greece next month on oil policy matters. That trip is certain to produce some interesting OEI columns.
For now, I want you to understand that the simple options spread between oil and currency is not likely to be as successful moving forward.
This spread has provided some with a ready vehicle for short-term profits. However, basic market parameters will soon be reasserting themselves. A trader cannot offset the bias for crude price increases for very long, nor can he or she expect to marginalize the other factors impacting the forex rate.
For us, this has been an interesting depiction of how options trading both reflects and influences the oil market.
Those lessons have been useful in developing the options strategy I am getting ready to unveil for Energy Advantage members – as a supplement to our existing trades in stocks and ETFs. (If you’re not yet a subscriber, click here to learn more.)
Don’t see why the heavy hitters should be the only ones profiting from options trading.