The crude oil options market is booming, driven as much by sophisticated new trading strategies as by speculators trying to duplicate the dazzling profits earned by the lucky few who bet early last year that oil would nearly double from its lows near $50 a barrel.
As of January 9, open interest in NYMEX crude oil options stood at 3.93 million contracts, up 27 percent from January 2007 and 82 percent higher than January 2006, according to the New York Mercantile Exchange.
Some investors have been paying rich prices for contracts that cannot be exercised for years. December 2010 $100 call options - which give holders the right to buy a December 2010 oil futures contract for $100 a barrel - have traded as high as $7 a barrel in recent weeks.
The high prices being paid for some options have led some veteran oil futures traders to dismiss the options boom as the latest sign of hot money chasing easy profits.
But other market watchers note that the stomach-churning price swings that have become commonplace in the oil market make options part of a more sensible investing strategy for both speculators and commercial traders.
The flat price is a very difficult situation to deal with because of the volatility, said John Kilduff, senior vice president at MF Global in New York.
If you trade the flat price you are either a hero or a goat from day one. With the options, you give yourself the latitude to have the position grow into being right or wrong.
Options also offer a cheap and less risky way to place bets on dramatic moves in the price of oil.
As of January 9, oil investors held 5,533 $200 December 2008 call options CL2000L8, which have traded between 20 and 55 cents per barrel. Options strategists note that oil does not have to rise to $200 a barrel for these positions to be profitable.
From the option traders' perspective, all that is needed to profit in this position is some more people to think the same way. It would not take much to boost the value of that contract, which is an efficient way to go long crude oil futures for the end of the year, said Andrew Wilkinson, senior market analyst at Interactive Brokers Group in Greenwich, Connecticut.
Growing liquidity in the options market has also allowed oil investors to take more sophisticated positions on the direction of the longer-term price of oil.
Long term prices have risen sharply, but remain far below the levels seen in today's market. December 2010 oil futures settled at $86.42 a barrel on Wednesday, almost $10 a barrel below the front-month February 2008 contract, which settled at $95.67 a barrel.
Options investors are betting heavily that the long-term price will continue to rise. Over 27,000 December 2010 $100 call contracts were outstanding as of January 9 when they settled at $6.18 a barrel.
The heavy bets are not only going into call options that give investors exposure to another dramatic increase in oil prices. Contracts that protect investors against a fall in oil prices are also attracting considerable interest.
According to Reuters data, over 60 percent of the outstanding oil options on the New York Mercantile Exchange are put options, which give the holder the right to sell an oil futures contract at a set price.
For instance, June 2009 $70 put contracts settled at $2.37 a barrel on January 9 even though the underlying June 2009 futures contract settled at $87.45 that day.
Analysts say these prices reflect the growing demand from investors for insurance against volatility in the oil market. Nontraditional investors, such as pension funds, are starting to use oil options to cut the overall volatility of their entire investment portfolio, analysts said.
You could own a portfolio of oil producers and when you crunch the numbers on an earnings metric, buying that oil put option all of a sudden insulates your equity portfolio from a fall in world prices, said MF Global's Kilduff.
(Additional reporting by Doris Frankel in Chicago; Editing by Marguerita Choy)