Welcome back to my weekly column. I am sorry I could not write last week due to unforeseen circumstances and I hope all of you had a fantastic Independence day long weekend.
Last week, investors sold off on the long weekend and the higher loss of non-farm payrolls, suggests that even though the economic outlook is optimistic going forward, the current situation may make the going tough for some industries at the moment.
Yes, most consumer related industries are still very much in the doldrums and one of those that is being hit by the higher loss of non-farm payroll is crude oil.
August crude futures dropped by $2.58 to its lowest closing level for front-month contracts since 3rd June as demand for oil continues to stagger. Crude oil inventories also rose for the first time in five weeks last week despite falling supplies, proving the lower demand. In fact, gasoline at the pump this summer is only a third the price of last summer. Crude oil's surge over the last few months also gave a sense of it being overbought in the market. Also weighing on crude oil price is the strength that the US dollar has displayed over the past month. As such, many crude oil traders are now calling a short term bearish outlook on crude oil. So, how does an options trader trade a bearish outlook on crude oil?
As options traders, we can trade with a potential risk reward ratio of 2 : 1 using a Jul33/36 Bear Put Spread on the ETF for crude oil called USO. USO is an exchange traded fund that tracks the price of crude oil. Any traders can trade USO through the stock exchange in order to speculate on the price of crude oil without being directly involved in the commodities or futures market. USO is also optionable, which means that it comes with exchange traded options, which are highly liquid.
A Bear Put Spread is a speculative bearish options strategy which speculates on a moderate decline in the price of the underlying stock. The maximum profit potential of the bear put spread is usually much higher than its potential risk. In this case, we are working on a potential maximum profit of 2 times the maximum possible loss. The Bear Put Spread consists of buying an at the money or slightly out of the money put option and then offsetting the price of those put options by writing (shorting in stock trading terms) out of the money put options at the strike price which the stock is most likely to correct to. The higher risk reward ratio of the Bear Put Spread comes from this offsetting of the initial cost of owning put options. In this case, since we are expecting a quick and moderate drop in the price of USO, we could go for the front month July options (yes, it's a lot more aggressive than most would like to. The August options work as well but the pullback may not last that long to justify the short put options), and with a technical support level at about $33, we could write the $33 strike price put options. The July $33 put is bidding for $0.30 and the $36 put is asking for $1.25 as of last Thursday's close. Buying the $36 strike put options and writing the $33 strike put options will result in a net debit of $0.95. The maximum profit is $2.05 when USO drops to or exceeds $33.
The advantage of using a bear put spread rather than just buying put options in this case is the fact that the pull back in USO is expected to be moderate and quick instead of sustained and deep. By using a Bear Put Spread, you put lesser money at risk per position and yet profit the same way from a moderate drop to $33. Otherwise, if the drop in USO is expected to be long, sustained and deep, an outright put option with a longer expiration would make a lot more sense.
In this case, if the USO drops to $33 or lower, the position returns a value of $3.00, which is a profit of $2.05 after deducting the initial investment of $0.95. If USO remained stagnant or rallies and closes above $36, you would have only lost $0.95, which is your initial debit.
Yes, the maximum loss in a Bear Put Spread is your initial debit payment. This is why we only use money we can afford to lose in a Bear Put Spread. First, you determine your maximum risk tolerance and then commit no more than that amount of money into the position. For instance, if you want to lose no more than $500 in a single trade, then you should use no more than $500 in this position.
How might this trade work out?
The odds are favorable that the USO would be short term bearish due to the reasons mentioned and also due to the intermediate pullback that is happening in the market now. The USO has been surprisingly correlated with the Dow and S&P-500 ever since this economic crisis begun. In fact, oil was believed to move opposite to stocks but it was not the case since late 2008. In fact, USO now has a beta of 1.01, which means that it is expected to almost move in step with the overall stock market now. We will monitor and see how this trade works out.
Lets look at our past trades...
DRYS continues to be weak with the overall market. Its Sep 7.5/11 Bull Call Spread is now worth merely $0.20. However, we still have until September expiration for DRYS to recover.
EEM pulled back off $37 as we have expected and has dropped more than 7% since. As long as it remains below $37, the position would stand to profit.
AAPL has been going sideways since we covered it and the naked put write looks good to profit in full as long as AAPL remains above $130.
Read my past coverage on:
Disclaimer : Neither I nor Masters 'O' Equity or Optiontradingpedia.com and any of the staff, own any shares in DRYS nor hold the above mentioned options trading position. The above article uses closing prices on 5 June 2009. Actual prices on Monday opening may differ. This article is for education purpose only and should not be taken as individual investment recommendation. Options trading is not suitable for everyone and advise should be sought from your local financial adviser.