How To Buy Oil Options

American crude oil option position

After exercise of respective crude oil options

Long call option

Long futures

Long put option

Short futures

Short call option

Short futures

Short put option

Long futures

Example with American Calls

For instance, let’s assume that on Sept. 27, 2021, a trader named Helen bought American-style call options on April 2022 crude oil futures. The choices strike price is $90 per barrel. On Nov. 1, 2021, the April 2022 futures price is $96 per barrel; Helen desires to exerwcise her call options. By exercising the choices, she enters into an extended April 2022 futures position on the locked-in price of $90. She may decide to wait until expiration and take the delivery of physical crude oil underlying the futures contract, or else close the futures position immediately to lock in $6 ($96 – $90) per barrel. Considering the contract size on one crude oil option is 1,000 barrels, the $6 per barrel could be multiplied by 1000, yielding a $6,000 payoff from the position.

Example with European Calls

European-style oil options are settled in money. Note that, in contrast with American-style options, European-style options may only be exercised on the expiration date. On the expiration of an in-the-money call option, its value can be the difference between the settlement price of the underlying crude oil futures and the choice strike price multiplied by 1,000 barrels. Conversely, an in-the-money put option can be well worth the difference between the choice strike price and the underlying futures settlement price, multiplied by 1,000, at expiration.

For example, assume that on Sept. 27, 2021, trader Helen buys European-style call options on April 2022 crude oil futures at a strike price of $95 per barrel, and that the choice costs $3.10 per barrel. Crude oil futures contract units are 1,000 barrels of crude oil. On Nov. 1, 2021, the April 2022 crude oil futures price is $100 per barrel and Helen wishes to exercise the choices. Once she does this, she receives ($100 – $95)*1000 = $5,000 as payoff on the choice. To calculate the online profit for the position, we’d like to subtract the price of options (the choice premium paid to the vendor) of $3,100 ($3.1*1000). Thus, the online profit on the choice position is $1,900 ($5,000 – $3,100).

Oil Options Vs. Oil Futures

Options contracts give purchasers the fitting, but not the duty, to purchase (call option) or sell (put option) the underlying asset at a preset strike price. Probably the most a crude oil option holder can lose is the price paid for the choice, reasonably than the price of the underlying futures contract. Futures contracts require more capital for a given level of exposure relative to options and wouldn’t have options’ asymmetric return characteristics.

Oil options don’t require physical delivery at expiration, as is the case with some (but not all) crude oil futures contracts. European-style oil options are money settled, providing money payouts to holders of in-the-money options at expiration. In contrast, crude oil futures traded on the NYMEX require delivery at expiration. The trader short one futures contract must deliver 1,000 barrels of crude oil at the desired delivery point, while those with an extended position must accept delivery.

Where the initial margin requirement of futures is higher than the premium required for the choice on a comparable exposure, option positions provide more leverage. For instance, imagine that NYMEX requires $2,400 as an initial margin for one crude oil futures contract that has 1,000 barrels of crude oil because the underlying asset. An option on that futures contract may cost $1.20 per barrel. A trader considering those alternatives could buy two oil option contracts that will cost exactly $2,400 (2*$1.20*1,000) and represent 2,000 barrels of crude oil. It’s value noting, nonetheless, that the inherent leverage of options can be reflected in the choice price.

In contrast to crude oil futures, the long call/put crude oil options should not margin positions; thus, they don’t require any initial or maintenance margin, and wouldn’t trigger a margin call. This helps the long option position trader wait out price fluctuations. The futures trader may have to supply additional capital should their margined positions lose value. Long option contracts help to avoid this.

Traders have the chance to gather premiums by selling crude oil options (and assuming the inherently much higher risk of short option positions). For traders who expect rangebound prices, crude oil options can provide a possibility to earn a premium by writing (selling) out-of-the-money options. Recall that a brief option position collects the premium and assumes the danger. Selling out-of-the-money options, be they calls or puts, may enable the vendor to retain the premium should the choice expire out-of-the-money. Futures contracts don’t provide an identical opportunity.

The Bottom Line

Traders who seek to extend leverage or secure an asymmetric return profile may decide to trade crude oil options on the NYMEX or one other exchange. In return for a premium paid upfront, oil option holders obtain a non-linear risk/return profile not available in futures contracts. Moreover, long options traders don’t face margin calls that may require future traders to supply additional margin capital for a devalued position. European-style options are optimal for traders preferring money settlements.

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