Monday, September 28, 2009

Oil Triple Play- Part I

Given the bearish price action recently experienced in black gold as well as "weak economic data" our Options Action pundits suggested two potential plays on the United States Oil fund (USO).

For those of you unaware, the USO is an exchange traded fund designed to:

"...reflect the changes in percentage terms of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the changes in the price of the futures contract for light, sweet crude oil traded on the New York Mercantile Exchange (the “NYMEX”), less USO’s expenses."

In layman's terms, the USO tracks crude oil. In addition to tackling the two strategies highlighted by our Options Actions pals, I'll also take a look at a third potential strategy mentioned in this week's IVolatility Trading Digest Blog.

Play #1: Bearish 1 x 2 put spread
The first suggested strategies was a bearish 1x2 put spread involving November put options.
Long 1 Nov 33 put @ $1.70
Short 2 Nov 30 puts @ $1.60
Net Debit = $.10

The 1x2 put spread, explained in my recent post on Best Buy earnings, can be thought of as a normal bear put spread with an additional naked put. The suggestion was to buy a 33-30 put spread and simultanously sell a 30 strike naked put. To realize our maximum profit on the put spread we need the stock to drop to $30. However, since we're short an additional 30 put option, we can potentially lose money if the stock drops too much. Based on the risk graph below, our profit zone resides between $27.15 and $32.80. Although this is a bearish trade, if USO drops more than 21% (below $27.15), it could turn into a loser. The odds of USO dropping over 21% are very small in my opinion. Furthermore, if it did drops that far I wouldn't mind getting long the stock at those prices anyways.

[Source: EduTrader]

In addition to the downside risk of the USO falling too far, we are also risking the net debit of $.10 if USO remains above $33 at November expiration. This is one of the advantages to this specific strategy- minimal upside risk. Take a look at the risk graph juxtaposed with the price chart (click image to enlarge).
[Source: EduTrader]
Variation Idea: One may consider using the 31 strike instead of 30. Currently the Nov 33-31 put spread is trading around $.30 credit. Although this raises your lower breakeven, it eliminates any upside risk because if USO is above $33 at Nov expiration you keep the $.30 credit. I personally like the risk-reward characteristics of using the 31 strike better.

Next time we'll explore the second strategy.

For past commentary on the USO check out: