Buying Heating Oil Call Options to Profit from a Rise in Heating Oil Prices

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Contents

Buying Heating Oil Call Options to Profit from a Rise in Heating Oil Prices

If you are bullish on heating oil, you can profit from a rise in heating oil price by buying (going long) heating oil call options.

Example: Long Heating Oil Call Option

You observed that the near-month NYMEX Heating Oil futures contract is trading at the price of USD 1.4777 per gallon. A NYMEX Heating Oil call option with the same expiration month and a nearby strike price of USD 1.5000 is being priced at USD 0.1000/gal. Since each underlying NYMEX Heating Oil futures contract represents 42000 gallons of heating oil, the premium you need to pay to own the call option is USD 4,200.

Assuming that by option expiration day, the price of the underlying heating oil futures has risen by 15% and is now trading at USD 1.6990 per gallon. At this price, your call option is now in the money.

Gain from Call Option Exercise

By exercising your call option now, you get to assume a long position in the underlying heating oil futures at the strike price of USD 1.5000. This means that you get to buy the underlying heating oil at only USD 1.5000/gal on delivery day.

To take profit, you enter an offsetting short futures position in one contract of the underlying heating oil futures at the market price of USD 1.6994 per gallon, resulting in a gain of USD 0.1990/gal. Since each NYMEX Heating Oil call option covers 42000 gallons of heating oil, gain from the long call position is USD 8,358. Deducting the initial premium of USD 4,200 you paid to buy the call option, your net profit from the long call strategy will come to USD 4,158.

Long Heating Oil Call Option Strategy
Gain from Option Exercise = (Market Price of Underlying Futures – Option Strike Price) x Contract Size
= (USD 1.6990/gal – USD 1.5000/gal) x 42000 gal
= USD 8,358
Investment = Initial Premium Paid
= USD 4,200
Net Profit = Gain from Option Exercise – Investment
= USD 8,358 – USD 4,200
= USD 4,158
Return on Investment = 99%

Sell-to-Close Call Option

In practice, there is often no need to exercise the call option to realise the profit. You can close out the position by selling the call option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the heating oil option sale will be equal to it’s intrinsic value.

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Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

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Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Buying (Going Long) Heating Oil Futures to Profit from a Rise in Heating Oil Prices

If you are bullish on heating oil, you can profit from a rise in heating oil price by taking up a long position in the heating oil futures market. You can do so by buying (going long) one or more heating oil futures contracts at a futures exchange.

Example: Long Heating Oil Futures Trade

You decide to go long one near-month NYMEX Heating Oil Futures contract at the price of USD 1.4777 per gallon. Since each NYMEX Heating Oil Futures contract represents 42000 gallons of heating oil, the value of the futures contract is USD 62,063. However, instead of paying the full value of the contract, you will only be required to deposit an initial margin of USD 10,125 to open the long futures position.

Assuming that a week later, the price of heating oil rises and correspondingly, the price of heating oil futures jumps to USD 1.6255 per gallon. Each contract is now worth USD 68,270. So by selling your futures contract now, you can exit your long position in heating oil futures with a profit of USD 6,206.

Long Heating Oil Futures Strategy: Buy LOW, Sell HIGH
BUY 42000 gallons of heating oil at USD 1.4777/gal USD 62,063
SELL 42000 gallons of heating oil at USD 1.6255/gal USD 68,270
Profit USD 6,206
Investment (Initial Margin) USD 10,125
Return on Investment 61.2972%

Margin Requirements & Leverage

In the examples shown above, although heating oil prices have moved by only 10%, the ROI generated is 61.2972%. This leverage is made possible by the relatively low margin (approximately 16.3140%) required to control a large amount of heating oil represented by each contract.

Leverage is a double edged weapon. The above examples only depict positive scenarios whereby the market is favorable towards you. If the market turn against you, you will be required to top up your account to meet the margin requirements in order for your futures position to remain open.

Learn More About Heating Oil Futures & Options Trading

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

How To Buy Oil Options

Crude oil options are the most widely traded energy derivative on the New York Mercantile Exchange (NYMEX), one of the largest derivative product markets in the world. The underlying asset for these options is not actually crude oil itself, but crude oil futures contracts. Thus, despite the name, crude oil options are in fact options on futures.

Both American and European types of options are available on NYMEX. American options, which allow the holder to exercise the option at any time over its maturity, are exercised into underlying futures contracts. For instance, a trader who is long on American call/put crude oil options takes long/short position on the underlying crude oil futures contract.

Key Takeaways

  • Investors, speculators, and hedgers can use options in the oil market to gain the right to purchase or else sell physical crude or crude futures at a set price before they options expire.
  • Options, unlike futures, do not have to be exercised on expiration, giving the contract holder more flexibility.
  • Oil options come in both American and European varieties and trade in the U.S. on the NYMEX exchange in New York as well as electronically on the ICE exchange.

Call Option Payoffs

The table below summarizes the American option positions that, once exercised, results in the respective underlying futures position shown in the second column.

American crude oil option position

After exercise of respective crude oil options

Long call option

Example with American Calls

For example, let’s assume that on September 25, 2020, a trader named Helen takes a long call position on February 2020 American crude oil options. The futures strike price is $90 per barrel. On November 1, 2020, the February 2020 futures price is $96 per barrel; Helen wants to exercise her call options. By exercising the options, she enters into a long February 2020 futures position at the price of $90. She may choose to wait until expiration and accept the delivery of the crude oil at the locked-in price of $90 per barrel, or she may close the futures position immediately to lock in $6 (= $96 – $90) per barrel. Taking into account that the contract size on one crude oil option is 1,000 barrels, the $6 per barrel would be multiplied by 1000, thus yielding a $6,000 payoff from the position.

Example with European Calls

The European type of oil options are settled in cash. Note that, contrary to American options, European options may only be exercised on the expiration date. On expiration of a call (put) option, the value will be the difference between the settlement price of the underlying Crude Oil Futures (strike price) and the strike price (settlement price of the underlying Crude Oil Futures) multiplied by 1,000 barrels, or zero, whichever is greater.

For instance, assume that on September 25, 2020, Helen the trader enters into a long call position in European crude oil options on February 2020 crude oil futures at a strike price of $95 per barrel, and that the option costs $3.10 per barrel. Crude oil futures contract units are 1,000 barrels of crude oil. On November 1, 2020, the crude oil futures price is $100/barrel and Helen wishes to exercise the options. Once she does this, she receives ($100 – $95)*1000 = $5,000 as payoff on the option. To calculate the net profit for the position, we need to subtract the option costs (the premium that the long option position pays to the short option position at the beginning of the transaction) of $3,100 ($3.1*1000). Thus, the net profit on the option position is $1,900 ($5,000 – $3,100).

How To Buy Oil Options

Oil Options Vs. Oil Futures

  • Options contracts give holders (of long positions) the right, but not the obligation, to buy or sell (depending on whether the option is call or put) the underlying asset. Thus, options have a non-linear risk-return profile that is best for those crude oil traders who prefer downside protection. The most a crude oil option holder can lose is the cost of the option (premium) that is paid to the option writer (seller). Futures contracts, however, do not give such an opportunity to contract sides, since they a have linear risk-return profile. Futures traders can lose the entire position during an adverse movement of the underlying price.
  • Traders unwilling to bother with physical delivery, which might require a lot of paperwork and complex procedures, may prefer oil options to oil futures. More specifically, European options are cash settled, meaning that once the options are exercised, the option holder receives the positive payoff in cash. In this case, the delivery and acceptance are not an issue for the contract sides. The crude oil futures traded on NYMEX, however, are physically settled. The trader who has a short position on one futures contract must deliver 1000 barrels of crude oil at expiration, and the long position must accept the delivery.
  • Where the initial margin requirement of futures is higher than the premium required for the option on similar futures, option positions offer extra leverage by freeing some of the capital required for the initial margin. For example, imagine that NYMEX requires $2,400 as an initial margin for one February 2020 crude oil futures contract that has 1000 barrels of crude oil as the underlying asset. We can find a crude oil option on February 2020 futures that costs $1.2/barrel. Thus, a trader can buy two oil option contracts that would cost exactly $2,400 (2*$2.1*1,000) and represent 2000 barrels of crude oil. It is worth noting, however, that the lower price of the options will be reflected in the moneyness of the options.
  • In contrast to the futures position, the long call/put option positions are not margin positions; thus, they would not require any initial or maintenance margin, and furthermore would not trigger a margin call. This in turn enables the long option position trader to better sustain price fluctuations without any additional liquidity requirement. The trader must have enough liquidity to support short-term price fluctuations. Long option contracts help to avoid this.
  • Traders have the opportunity to collect premiums by selling (thus assuming high risks) crude oil options. If traders do not expect the crude oil prices to strongly change in any direction (up or down), oil options create an opportunity for them to earn a profit by writing (selling) out-of-the-money oil options. Recall that a short option position collects the premium and assumes the risk. Thus, selling out-of-the-money options, be it call or put, will enable them to profit from premium collection should the option end up out-of-the-money. Futures contracts by nature do not include any upfront payments, therefore they do not offer this type of opportunity to the traders.

The Bottom Line

Traders who seeks downside protection in crude oil trading may want to trade crude oil options that are traded mainly on the NYMEX. In return for a premium paid upfront, oil option holders obtains non-linear risk/return not normally offered by futures contracts. Additionally, long options traders do not face margin calls that require traders to have enough liquidity to support their position. European options are optimal for traders who prefer cash settlements.

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