You may have noticed that the regular trips to the pump are costing a little more than they used to lately, thanks to that sweet, Texas black gold. In fact, oil has risen by over 10% over the past month from a low of $65.22 to $71.89. These kinds of moves bring a lot more attention to this commodity, even bringing it to the top of this trader’s mind.
By using options, one could simultaneously make a trade that oil will continue to rise or that oil will fall and yet have the same probability of profit. Sounds like I’ve been drinking something stronger than Dr. Pepper? Well, let me show you how this can be done.
So let’s take a look at this trade using SPDR Oil & Gas Exploration ETF (NYSE: XOP), which has had a 10% move itself over the last month. As of May 22, 2018, the closing price of XOP was $43.08. By buying a share of XOP, it would only profit if XOP goes up, and the opposite is true if it were sold short. So how can a trade be made so that either direction has a high probability of profit? This can be accomplished by selling-out of the money options.
Let’s say we have a bearish assumption and that we want XOP to go down in value, oil’s run is over and it can’t go any higher. We could sell a $46 call and buy a $47 call. This call spread in July is worth $24, so if oil goes down, sideways or up to our breakeven of $46.24 (the $46 call plus the credit of the spread) then this trade would be profitable.
Or let’s assume that oil’s run is just getting started. Oil is going to the moon! We could sell a $41 put and buy a $40 put for $29. So if Oil goes up, sideways or down to our breakeven of $40.71 (the $41 put minus the credit of the spread) then this trade would be profitable.
The best part of all this, either one has practically the same probability of profit! The $46/$47 call spread has a probability of profit around 70% and the $41/$40 put spread also has a probability of profit around 70%. How can this be?
The delta of the $46 call is 30 and the delta of the $41 put is negative 30. Delta is an approximate measure of the probability of a strike being in-the-money at expiration. When an option is sold, it requires the seller to pay the buyer the difference of the in-the-money strike price and the closing price of the stock at expiration.
But if the strike expires out-of-the-money, the seller keeps all the premium the buyer paid. So with both options having a delta of 30 for the short strike, then they both have a probability of expiring out-of-the-money of 70%. Which is 100% minus the delta value.
Now this kind of trade can fit any portfolio.
With the spread being $1 wide, the max loss of the trade would only be the difference in the spread width and the credit received. So for the put spread, the total margin required on the trade is only $71 ($100 to $29). So whether you’re bullish, bearish or neutral on how oil is going to trend over the next several weeks, there is an options strategy to fit your view and your portfolio.
Contributor : Christopher Uhl, from www.10minutestocktrader.com