How to trade oil

You might be tempted to avoid oil in this environment, but there are many strategies you can use to take advantage of the volatility in this commodity.

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We can see (courtesy of the Nasdaq) that Oil is on a downward trend, an exceptionally volatile one. It has fluctuated from $36 to $28, to $34 to $26. That’s shifts of -28.57%, +21.43% and -23.53%. Although the graph suggests oil has yet to bottom out I don’t outrightly recommend shorting. The supply of oil is a relatively known metric, and there is arguably an over-reaction to fears over demand in China. The Chinese slowdown has been anticipated for years and it is an important medicine to take to help their transition to a developed economy. Therefore oil is likely to have been oversold in this current market and I suspect will level out closer to $40-$60.

Until this happens it is possible to take advantage of the volatility. A trade known as the strangle involves buying a call and a put option, for the same ‘type’ of oil (e.g. WTI, Brent etc) and at the same expiry date. However, you buy the call at a higher exercise price and a put at a lower exercise price. This is diagrammatically shown below.

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The put option is only exercised if the price of oil falls below K1. When that occurs you receive a payout, which becomes profitable when the bold line breaches the St line, i.e. when K1 minus the combined premium of the call and put = 0. Similarly when the price of oil rises above K2 the strangle begins to profit. Between K1 and K2 the strangle makes a loss, equal to total premium paid for the call and put option. This is shown in the table below.

Screen Shot 2016-02-11 at 17.32.02

When the oil price rises above $37 or falls below $28 the strangle begins to profit. However when the oil price remains between $30 and $35 the strangle loses the same amount as the premium paid for both options. That way you have a guaranteed downside, helping minimise risk, and if the oil behaves as it has down throughout January and February you are likely to profit.

This strategy is seen as more effective than the straddle strategy because the use of a call and a put at different expiries reduces the total premium paid, as a lower K for the put option means the put option costs less. However it is worth mentioning that close attention must be paid to the premiums paid. It is quite clear at the moment that oil is volatile, which means that trades like this are very popular. This will raise the premium of the options and could result in the premiums being so high that this strategy is unviable.

Twitter: @ProdigyMarkets

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