MCO: Options Strategy to Capture Crude Oil VolatilityNYMEX: Options on Micro WTI Crude Oil ( NYSE:MCO ), Underlying Futures: NYMEX:MCL1!
Riding on last week’s story on TradingView, “Would the Middle East Conflict Push Gold and Oil Prices Higher?” let’s explore option strategy to hedge event risk.
Last week, we’ve revisited the event driven strategy and how it could be leveraged to hedge event risk:
• I observe that gold prices usually go up in the aftermath of a crisis, as evidenced by its 24% surge in six months after the start of the Covid pandemic.
• If a crisis results in economic recession, crude oil prices would go down. Proof: WTI dropped nearly 80% one month after Covid, as lockdowns destroyed oil demand.
• In the event of a war, oil prices shot up due to its strategic importance. Example: Crude was up 31% one month after the start of the Russia-Ukraine conflict.
• What’s in store to hedge event risk? We explored long futures strategies on COMEX Gold and NYMEX WTI.
For my original idea on event driven strategies, please read this:
Are these strategies working? We can review them in real time. Micro Gold goes first:
• On October 6th, the last trade day before event date (denoted as T0), Gold Futures (T0) = $1,845 per troy ounce for the leading December contract MGCZ3.
• Price changes by time: at (T+1): $1,864.3, +1.0%; at (T+7): $1,941.5, +5.2%
• Hypothetically, if we opened a long futures position at T0 price and hold it till now, our futures account will gain by $965 (= (1941.5-1845) * 10).
• If we take the $780 initial margin deposit as cost base, our theoretical return would be +23.7% (=965/780-1), excluding transactions fees.
For WTI crude oil futures:
• Futures (T0) = $83.18 per barrel for December contract (CLZ3).
• Price changes by time: at (T+1): $84.60, +1.7%; at (T+7): $86.35, +3.8%
• Hypothetically, a long futures position would gain by $3,170 (= (86.35-83.18) * 1000).
• The theoretical return would be +51.2% (=3170/6186-1), excluding commissions.
• We could replicate this strategy using Micro WTI futures ( CSE:MCL ), which is 1/10 of the standard NYSE:CL contract and requires 1/10 of initial margin.
Today, I would like to explore options strategy on crude oil, and hope to achieve better results in a cost-effective way.
As we know, neither Israel nor Palestine is a major oil producer. So far, global oil supply has not been interrupted by this military conflict. Rising oil price is due to the “price shock” arising from a geopolitical event.
However, if the conflict intensifies, it could drag other oil producing nations from the region into conflict. At wartime, there is a real risk of oil field sabotage or blockage of major shipping routines. Either one could result in an oil supply shortage.
If you can’t buy a bar of gold, you could choose alternative investment options like bonds or bitcoin. But if we don’t have oil, all other energy sources combined are not sufficient to fill the gap. We would not be able to refill the gas tank. Delivery trucks could not ship meat and vegetables to local grocery stores. There will be a real crisis.
Options Strategy with Micro WTI Crude Oil Options
In its first week, the conflict has already resulted in thousands of casualties. With the ground fighting in Gaza due to begin any time, the conflict could quickly get out of control in the coming days and weeks.
For a comparison: Last year, WTI went up 5.7% one week after the start of the Russia-Ukraine conflict. By the end of the first month, crude oil was up 31%.
This time, WTI went up 3.8% in Week 1. Where will oil price be at T+1M? With a “Risk On” scenario like last year, it could go up another 25%, reaching $105 or higher.
However, a long-only futures strategy runs the risk of oil price going down. In this rapidly evolving event, senior US officials are in the Middle East negotiating for a cease fire. If peace is achieved, it is good for the world. How do we hedge a long-futures position in a “risk-off” scenario?
We could consider a Call Strategy with the Options Contract ( NYSE:MCO ) on Micro WTI Crude Oil Futures ( CSE:MCL ).
In the following example, I would illustrate the theoretical payoffs between a long futures position on MCL and an out-of-the-money (OTM) Call with MCO.
Market prices and assumptions:
• On October 13th, settlement price for MCLZ3 was $86.35/barrel.
• For a simplified example, assume there are two possible outcomes in one month. Risk-On: WTI goes up 20% to $103.62. Risk-Off: WTI goes down 20% to $69.08.
Futures Trade:
• Buy MCLZ3 at T0 settlement. Upfront investment is the $640 initial margin.
• Risk-On: Position gains $1,727 (= (103.62-86.35) * 100). Return: +270% (=1727/640).
• Risk-Off: Position lost $1,727 (= (69.08-86.35) * 100). Return: -270% (=-1727/640).
• In actual trades, when the account balance drops below 22% of the initial margin to $140.8, the trader will be required to bring the balance back up to $640.
Options Trade:
• Buy a $95 call on MCLZ3 on T0 at $2.02 premium. Total premium is $202, as each contract is 100 barrels of crude oil.
• Risk-On: Call strike will be $8.62 in-the-money (ITM, =103.62-95). At today’s market, the 77.75-strike at futures price $86.35 is $8.60 ITM. It is quoted $9.71. Using this as an approximation, we assume our options value to go up from $2.02 to $9.71.
• Position would gain $769 (= (9.71-2.02) * 100). Return: +381% (=769/202).
• Risk-Off: Call strike will be $25.92 OTM (=95-69.08). Today, the 112.25-strike is 25.9 OTC at current market price. It is quoted $0.58. If we sell the options at the open market, we will realize a loss of $144 (= (0.58-2.02) * 100). Return: -71% (=-144/202).
Unlike the physically deliverable standardized WTI contracts, Micro WTI futures ( CSE:MCL ) and options ( NYSE:MCO ) are both financially settled. To exit the position, the trader will enter a trade at the opposite direction. In our examples, a Short December futures MCLZ3 will offset the Long position. For the options trade, selling the same call options will net out the existing position.
What are the advantages of an options strategy vs. a futures trade?
Firstly, the upfront investment could be much lower with an OTM call. In our example, it is $202, compared to $640 for futures margin.
Secondly, a trader could design more complex trading strategies using options. There are multiple calls and puts to serve as building blocks, compared to only one futures contract for each expiration.
Thirdly, options payoff is nonlinear. When you are on the right side of the market, the return grows exponentially larger as the call strike gets deeper in-the-money. In our illustration, the same price increase results in 380% gain for options, vs. 270% for futures.
Finally, buying a futures contract could incur unlimited losses. If the market goes against you, you could lose more than the initial margin as you may be required to put in more funds to meet margin call. On the other hand, the maximum loss from buying a call or put is capped to the upfront premium.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
