Profiting from Oil Prices with ETFs and Options

06/08/2009 10:44 am EST

Focus: COMMODITIES

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Oil prices are rising in the futures market, and oil companies are performing well in the stock exchange. A combination of rising inflation expectations and anticipated economic growth is likely driving the strong performance over the last several weeks. Whenever a trend like this emerges, investors will seek ways to profit from the opportunities. Many individual investors are unaware of how easy it is to invest directly in oil itself.

Traditionally, investors may have used futures to invest in oil, but this requires access to a futures account and large margin deposits that may be out of reach for most individual traders. Alternatively, you could buy oil company stocks, but these investments are exposed to the risk inherent in oil prices as well as the enterprise risk associated with running a business.

The solution to these problems are oil ETFs. An oil ETF is a great way to retain the convenience of a stock while benefiting from the rise in oil futures. One of these popular ETFs is USO (United States Oil Fund), which is traded on the stock market in the US.

As a fund, USO invests in oil futures and will rise and fall with those prices. This eliminates the risk associated with individual companies without requiring a futures account and margin deposits. This all sounds good, but why would a trader want to invest in oil in the first place?

Inflation

Oil is a way to hedge against rising inflation. Oil prices suffered from dramatic asset deflation at the end of 2008 and early 2009, but should rise when inflation expectations return. If inflation returns, it will cost more dollars to buy the same amount of oil, which drives USO's price up, creating profits for traders.

Growth

If growth returns to the US and the global economy, demand for oil and energy commodities will rise. This demand drives up prices. You can see the effect of economic growth on the price of oil during the last two economic expansions in the late 90's and mid 2000's.

Diversification

This is an important principle to integrate into a portfolio strategy. It is one of the few things you can do within your trading accounts that only provides benefits without disadvantages. Diversifying into commodities is one way to include an asset class that has limited correlation with stocks. This means that an investment in commodities could smooth your overall portfolio returns in the long run.

Traders interested in oil but looking for more leverage should look at the options on the USO ETF. Because the volume or liquidity is so high on the ETF, the spreads are fairly tight in the options. This is good because higher spreads add trading costs. If you were bullish on oil, calls or short puts are simple, single-leg option trades that could profit from even relatively small moves in the ETF.

By John Jagerson, of PFXGlobal.com and LearningMarkets.com.

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