Crude oil options are an essential tool for managing price risk and speculating on market movements in the oil industry.
What are crude oil options?
Crude oil options are derivatives or financial contract that give the buyer the right, but not the obligation, to buy or sell a specific type of crude oil at a predetermined price (strike price) on or before a certain date (expiration date).
In most cases, crude oil options do not require physical delivery at expiration. As such, the most a crude oil option holder can lose is the cost paid for the option.
Traders may collect 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 may allow them to earn a premium by selling out-of-the-money (OTM) options. short option position collects the premium and assumes the risk. Selling OTM call or put options may enable the seller to keep the premium if the option expires OTM.
There are two types of crude oil options:
- Call Option: Gives the buyer the right to buy crude oil at the strike price.
- Put Option: Gives the buyer the right to sell crude oil at the strike price.
READ: Crude Oil Buying and Selling Requirements in Nigeria
What’s the Difference Between Call and Put Options?
A call option gives the trader the right (but not the obligation) to buy the underlying asset at the specified price by the expiry date. The trader of a call option pays a premium for the contract. They look for a rise in the price of the underlying asset and gains are unlimited.
A put option, on the other hand, gives the trader the right (but not the obligation) to sell the underlying asset at the predetermined price when the contract expires. Like a call option, the trader pays a premium for a put contract but, in this case, the trader hopes for a drop in the price. Gains realized in put options, though, are limited.
Why trade options on oil?
- Options are leveraged products. When buying an options contract, you’re essentially gaining exposure to the full value of the market for a premium that’s a fraction of your total exposure.
- When buying an options contract, you set your own level of leverage and maximum risk when choosing the premium, you’re willing to pay
- Options on oil can be used to hedge against losses in an existing portfolio. For example, you can buy a put if you expect the value of your shares in an oil producing company to decrease
- Trading options using leverage derivatives may come with tax benefits in some territories
How to trade oil options
If you want to know how to trade options, it’s a good idea to learn how they work. With crude oil options, the underlying asset is crude oil. Once you understand the basics of the fundamentals of oil, choose the brokerage firm where you’ll open an account and begin trading. Decide which type of option you’ll trade, then pick your strike price (the price at which the contract will be set) and the expiry date.
Strike Prices:
- At-the-money (ATM): Equal to the current market price.
- In-the-money (ITM): More favorable than the current market price.
- Out-of-the-money (OTM): Less favorable than the current market price.
Expiration Dates:
- Short-term (e.g., daily, weekly)
- Long-term (e.g., monthly, quarterly)
- Understand how oil options work
Options are particularly complex instruments. Before trading with options, ensure that you understand how they work, how they’re priced, and what risks you face as a buyer or seller.
Crude Oil Options Contracts:
- NYMEX WTI Crude Oil Options: Traded on the New York Mercantile Exchange (NYMEX).
- ICE Brent Crude Oil Options: Traded on the Intercontinental Exchange (ICE).
- Learn what moves option prices
The value of an options contract will typically fluctuate during its lifespan, depending on the price of its underlying security, the time left until expiry, and the volatility of the market. Other variables like interest rates also influence its value.
- Choose to trade using CFDs
With CFDs, you enter into an agreement to exchange the difference in the price of an underlying asset, tracked from the time the contract is opened until it’s closed.
CFDs mirror the underlying market and have a predetermined value. In some regions, CFDs may be subject to CGT. However, you can hedge your position via CFDs so that your losses can be offset from profits
- Create a trading account
Applying for a live account takes just minutes. You’ll fill in an online form and once the application is complete, you’ll receive a notification when it’s accepted. Note that there’s no obligation to fund your account once opened, and you can wait until you’re ready to place your first trade.
- Determine your preferred expiry
The longer the time left to expiry, the more time value an option has, which means its premium is higher. Knowing how long you want to hold an option for is a fundamental aspect of options trading. This is especially important because the time value of an option decays more quickly as it nears expiry – thereby dropping the premium at an increased pace.
READ: GUIDE TO INVESTING IN OIL MARKET
Ways to trade oil options
- Trade oil options with CFDs
When you trade oil options with CFDs, your prediction mirrors the underlying options market. CFD options are traded in contracts that are worth a selected amount. This gives you less control over your deal size.
For example, if you buy a CFD on a call option worth $10 per point, the number of contracts you buy will multiply that amount. So, if you bought five contracts, you’d earn $50 per point the call option’s price moves beyond the strike, minus your margin.
CFDs are subject to capital gains tax (CGT) in some regions, though losses can be offset from profits. This ability to offset losses from profits for CGT purposes means that CFDs can be used as a hedging tool.1
All CFD trades are cash settled, so you never have to deliver, or take delivery of, physical barrels of oil.
- Trade oil options with a broker
Like oil futures, listed oil options are traded on registered exchanges. You have to meet certain requirements to buy and sell options directly on an exchange, so most retail traders will do so via a broker – which are limited in number.
When you trade with an options broker, you deal on their platform – usually paying commission on each trade – and they execute the order on the actual exchange on your behalf.
With an exchange, if you decide to exercise your options, they’ll be converted to oil futures contracts, which may require physical settlement. By comparison, CFDs are always immediately cash settled.