Long on Oil? Hedge Falling Oil Prices with Options

08/18/2015 8:00 am EST

Focus: OPTIONS

Given the broad sell-off, not just in oil, but in commodities across the board, Zaw Thiha Tun, at Investopedia.com, outlines how traders can use options as a risk management strategy to hedge against falling oil prices.

It's been over a year since oil prices began plummeting and the end appears to be nowhere in sight. The threat of Iranian crude oil pushing up supply, over production of oil in the United States, the rising dollar, and perceived slowdown in demand from Europe and China have all contributed to the broad sell-off, not just in oil, but in commodities across the board. In other words, proceed with caution. But what if you already own oil securities? With the possibility of further downside in mind, it would be prudent to have a risk management strategy to safeguard your existing long positions. In this article, we will discuss how to use options to hedge against falling oil prices. Note that the following options strategies are also applicable to futures trading.

Protective Puts

Let’s say you've decided to go against the grain and purchase 100 shares of United States Oil Fund LP (USO), an exchange-traded fund (ETF) that tracks front-month West Texas Intermediate (WTI) light, sweet crude oil futures. You purchase it at $16.34 per share. However, because oil prices have been volatile and falling, you begin to fear that USO will breach its all-time-low price of $15.61. In order to hedge or limit your risk, you can buy a put option on your 100 USO shares (the underlying asset). That way, no matter how low USO prices fall, the put option allows you to sell the shares at a specified price anytime before the option contract expires. For our example, the option contract may have an October 16 expiry, a $15 strike price, and is an out-of-the-money put. The option premium is $.64/share, so you pay $64 for your 100 shares. (Find more information about USO option chains here.)

By going long the shares of USO and going long on a put, you have created a protective put strategy. From now until the option expiry at the end of trading on October 16th, you will be able to sell your USO shares at $15 per share, regardless of how low they plummet on the market. If USO is trading at $10 by expiry, you will be able to exercise your option and sell your shares at $15, for a loss of only $1.98 per share or $198 total (($16.34 - $15) + put premium of $.64). If you had not bought the put option, you would have lost $6.34 per share or $634 total.

Sounds like a great deal, however, keep in mind that there is no free lunch in the world of options. By purchasing the put option, you have incurred an additional expense on your initial investment. This means that in order for you to break even on your investment, the shares of USO would have to rise high enough to cover the initial purchase price and the put premium. That is, USO would have to rise above $16.98 per share ($16.34 + $.64 put premium) for you to break even (for simplicity’s sake, we will disregard broker fees). Furthermore, like all insurance policies, should you not exercise your option, the protective puts will expire worthless. Though for some, $.64 is a small price to pay for the peace of mind.

NEXT PAGE: The Collars and the Bottom Line

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Put a Collar on It

What if you don’t like the idea of spending money on an insurance policy that you may or may not use? The collar strategy is another great tool for mitigating some, if not all, of the protective put’s cost. A collar is simply a protective put with a short call, simply go to the options chain for USO and look at an out-of-the-money call you’d like to write. In other words you would be the option seller. You would receive the option premium and in exchange you must sell the underlying USO stock at a predetermined price if the option buyer exercises the option. Say you decided to short the October 15, $17.5 strike call for $.68 against your put. Your new position looks like this:

  • Long 100 shares of USO at $16.34
  • Long an October 16 expiry, $15 strike price put option
  • Short an October 16 expiry, $17.5 strike price call option

The premium you received for selling the call will actually offset the premium you paid for buying the put (+$.68 versus -$.64), leaving you with a net gain of $.04 per share on your position or $4 total. In essence, you have created a floor (the put) and a ceiling (the short call) around your stock position. However, the caveat of the collar is that you are effectively capped at $17.5 on the upside. If your shares rise above $17.5, your short call will go in-the-money; the option buyer will exercise the option and you must the sell the USO shares at $17.5 per share...in other words, no matter how high the USO stock rises, you will not be able to reap any rewards past $17.50 per share. In this scenario, the maximum gain on your position would be $1.2 per share or $120 total (($17.5-$16.34) + $.04).

Three-Way Collars

Now, what if you are finicky investor? You don’t want to pay for insurance and you want the possibility of making more money than what the plain vanilla collar allows. Well, your prayers have been answered with the three-way collar, a collar with a short put on the downside (you can also think of this as a short call with a bear put spread). Three-way collars are actually quite popular forms of derivative hedging, especially in the oil industry. For example, Pioneer Natural Resources Company (PXD), an independent oil and gas company based in Texas, uses the three-way collar quite extensively.

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So how does it work? Well, it’s quite simple: just take the normal collar and short a put at a lower strike than your long put. For our USO example, this would entail shorting, say, the October 16, $14 strike put for $.34, bringing up your net credit to $.38: -$.64 for the long put, +$.68 for the short call and +$.34 for the lower strike short put. In other words, your position will be as follows:

  • Long 100 shares of USO at $16.34
  • Long an October 16 expiry, $15 strike price put option
  • Short an October 16 expiry, $17.5 strike price call option
  • Short an October 16 expiry, $14 strike price put option

Though you are still capped on the upside, you've managed to squeeze a bit more profit out of your trade if your bullish outlook pays off. However, by shorting a put on the downside, you have negated the protective put for prices below the short put’s strike. This means, that if USO fell to $10 as it did in the first example for the protective put, your long put will only be able to protect you until $14. Any further downside will trigger the short put to go in the money and you will then be obligated to purchase the shares of USO at $14 per share.

The Bottom Line

If you are tempted to be a contrarian and go long on oil, then it would be beneficial to familiarize yourself with some of the protection that options offer. Although the protective put, collar, and three-way collar offer varying levels of protection, there is always a tradeoff between risk and returns.

By Zaw Thiha Tun, Contributor, Investopedia.com

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