Options Trading Crude Oil

Last updated on February 15th, 2021

One sector of the market that continues to be very popular with active traders is the energy sector.

With energy prices so volatile, there are many products that traders can use to benefit from the back and forth price movement. The energy products are very sensitive to any type of fundamental or economic headline, geopolitical headlines, as well as the growth in the electric vehicle space.

As a result, we highly recommend every trader have access to the energy sector as part of their trading toolbox.

 

Oil Trading Products You Can Trade

We are going to take a look at the different oil related products that we like to use on our side to stay active in the energy sector. We can use a variety of products including:

  • Futures
  • Stocks
  • Options

Each of these have their pros and cons.

We are going to spend most of our time highlighting two of our favorite oil ETF’s that we like to trade using options.

Energy Sector ETF – Symbol: XLE

XLE is an ETF that tracks a market cap weighted index of US energy companies trading in the S&P 500. We love to trade this ETF as it gives as exposure to the energy sector using far less capital when compared to trading the shares of stock or the oil futures.

Oil futures are a very popular product with active traders.

The futures market can move very quickly and an in many cases produce large gains in a matter of minutes. The problem with trading futures is the cost associated with using the contracts. Depending on your broker, trading 1 oil futures contract will require over $6,000 in your account. For every $.01 that the futures contract moves, you will make or lose $10.

The futures contract is designed more for the short term day trader. While you can hold positions longer, as you can see above it will require a large amount of capital and can lead to large profits and losses if you aren’t careful.

In our opinion, XLE is a much better product to use to get exposure to the energy sector. It is a very liquid product with big volume in the shares of stock as well as in the options.

The price of XLE is going to be impacted the most by what Exxon Mobile (Symbol: XOM) and Chevron (Symbol: CVX) do as those two stocks make up 45% of the ETF.

XLE TOP STOCKS

Over 57% of the stocks that make up the ETF come from the Oil and Gas Refiners. While the ETF won’t be a direct correlation to the price of oil futures, they will provide a great way to get exposure to the energy sector for far less cost.

XLE has very liquid options in both the weekly and monthly options. This makes it easier to get in and out of trades quickly and at good prices.

While the weekly options are attractive in active markets, we prefer to use the monthly options in most cases. Our sweet spot is to look for between 20-60 days left to expiration with the options we are trading.

We will use a mix of long calls and puts as well as vertical spreads depending on market conditions. Using a mix of strategies will give us more flexibility in many market conditions.

XLE has a Daily ATR (Average True Range) of $1.38 which means it is an active product with a track record of good movement. Average daily volume on XLE comes in at just under 32 million shares which means this is a liquid product ideal for active traders.

United States Oil Fund ETF – Symbol: USO

If you are looking for an ETF with more of a direct correlation to the price of the Oil Futures markets then USO is a great product. It tracks the price of the WTI Crude Oil Futures contracts.

While this can be ideal for Oil traders looking for a cheaper product vs trading the futures markets, it doesn’t offer the flexibility that XLE does.

When trading USO we primarily stick to long calls and long puts. In most cases, the option prices are just too cheap and the liquidity isn’t good enough to trade vertical spreads.

We will use a mix of weekly and monthly options on USO over time as long as the options have between 20-60 days left to expiration. The monthly options will have better liquidity which make them easier to trade in most cases.

USO has a Daily ATR (Average True Range) of $.74 which is decent for a $36 ETF.

Average daily volume on USO stock comes in at just over 6 million shares.

The liquidity in USO makes it a good product for traders looking to take simple directional trades.

Trade Example – USO Long Put

Let’s start out with taking a look at a trade on USO using a long put option which would give us a bearish position. We mentioned earlier that we like to see between 20-60 days left to expiration on the options we are trading. This will have us looking at the March monthly options with 45 days left to expiration.

We like to trade options that are 1-2 strikes in the money (this will ideally give us an option with a Delta of around .60). In our example, we are going to take a look at buying the 38 put options which are trading for $2.30 or $230 per contract. The $230 is our maximum risk on the trade. That is a considerable cost savings when compared to using $6,000 to trade one futures contract.

We make money on this position as the stock moves lower over the next 45 days. Our typical holding time on a long put position is 3-15 days. This allows us to get in and out relatively quickly before the time decay kicks in too badly on the options.

Trade Example – XLE Call Credit Spread

Next we will take a look at using a vertical spread for a bearish position on XLE. We are going to stick with the March monthly options that have 45 days left to expiration. We are going to sell the 42/44 call credit spread to open the trade. This has us selling the 42 call to open and buying the 44 call to open at the same time. We are able to place this trade for $.62 or $62 per spread. This $62 that we are collecting to place the trade is the most we can make on the position. This trade is using $138 of capital per spread which is the most we can lose on the trade.

The beauty of using a credit spread is they give us 5 ways of making money on the trade. We make money on this trade from:

  • XLE moving up, down, or sideways as long as price stays below $42/share
  • We also make money from time decay adding up
  • Also from volatility decreasing

This trade is much more forgiving when compares to buying a long call or put option or buying an oil futures contract as we have multiple ways of making money.

We are in a fully risk defined trade which is a great feature of a spread. We can’t lose more than $138 per spread which is calculated by taking the $2 difference between the strikes and subtracting the $.62 that we collected to put the trade on.

Wrapping Up

As you can see above, XLE and USO both provide an inexpensive way to get exposure to the energy sector.

They are great alternatives to trading Crude Oil Futures which are far more aggressive and require more capital.

We love to use simple options strategies on these markets which still give us a nice return potential on the trades while doing so with much more forgiving type trades.

As active traders, we like to use many different markets to get the diversification that is necessary to make money long term in many market conditions.

Add XLE and USO to your watch list to take advantage of the volatile moves that take place on a regular basis in the Energy sector.

 

 

 

 

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