How to buy oil options

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

NYMEX offers American and European options. The American option allows the holder to exercise the option at any time after the option expires and is exercised into the underlying futures contract. For example, traders who are long American call/put crude oil options hold long/short positions on the underlying crude oil futures contract.

Key points

  • Investors, speculators and hedgers can use options in the oil market to obtain the right to buy or sell physical crude oil or crude oil futures at a set price before the option expires.
  • Unlike futures, options do not have to be exercised at expiration, giving contract holders more flexibility.
  • Oil options are available in the U.S. and Europe, and are electronically traded on the NYMEX exchange and ICE exchange in New York, USA

Call option return

The following table summarizes the American option positions, once exercised, the corresponding underlying futures positions shown in the second column will be generated.

U.S. crude oil options positions

After each crude oil option is exercised

Long call option

Long futures

Long puts

Short futures

Short-term call options

Short futures

Short option

Long futures

US phone example

For example, suppose that on September 25, 2014, a trader named Helen held a long call position in February 2015 US crude oil options. The execution price of the futures is US$90 per barrel. On November 1, 2014, the February 2015 futures price was US$96 per barrel; Helen wanted to exercise her call option. By exercising the option, she entered into a long futures position in February 2015 at a price of $90. She can choose to wait until maturity and accept delivery of crude oil at a locked price of US$90 per barrel, or she can immediately close the futures position to lock in US$6 per barrel (= US$96-US$90). Considering that the contract size of a crude oil option is 1,000 barrels, $6 per barrel will be multiplied by 1,000, resulting in a gain of $6,000 from the position.

European phone example

European oil options are settled in cash. Please note that, in contrast to American options, European options can only be exercised on the expiry date. When the call (put) option expires, 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 Whichever prevails.of

For example, suppose that on September 25, 2014, trader Helen entered a long call position in European crude oil options for February 2015 crude oil futures at a strike price of US$95 per barrel, and the cost of the option was US$3.10 per barrel. The crude oil futures contract unit is 1,000 barrels of crude oil.On November 1, 2014, the crude oil futures price was US$100/barrel, and Helen hopes to exercise the option. Once she does this, she will receive ($100 – $95)*1000 = $5,000 in return for the option. To calculate the net profit of the position, we need to subtract the cost of the option (the premium that the long option position pays to the short option position at the beginning of the transaction) 3100 USD (3.1 USD * 1000 USD). Therefore, the net profit of the option position is US$1,900 (US$5,000-US$3,100).

Petroleum Options vs. Petroleum Futures

  • Option contracts give the holder (long position) the right to buy or sell (depending on whether the option is up or down) the underlying asset, but there is no obligation. Therefore, options have non-linear risk-reward characteristics and are most suitable for crude oil traders who prefer downside protection. The biggest loss for crude oil option holders is the option cost (premium) paid to the option seller (seller). However, futures contracts do not provide such opportunities for contract parties because they have linear risk-reward characteristics. Futures traders may lose their entire position in the event of adverse changes in the underlying price.
  • Traders are reluctant to worry about physical delivery that may require a lot of paperwork and complicated procedures. They may prefer oil options to oil futures. More specifically, European options are cash-settled, which means that once the option is exercised, the option holder will receive a positive cash return. In this case, delivery and acceptance are not a problem for the contracting party. However, crude oil futures traded on NYMEX are physically settled. A trader holding a short position in a futures contract must deliver 1,000 barrels of crude oil at maturity, and a long position must accept delivery.
  • If the initial margin requirement for futures is higher than the premium of similar futures options, the option position provides additional leverage by releasing part of the capital required for the initial margin. For example, suppose NYMEX requires US$2,400 as the initial margin for a crude oil futures contract in February 2015, which uses 1,000 barrels of crude oil as the underlying asset. We can find crude oil options for February 2015 futures at a price of 1.2 USD/barrel. Therefore, a trader can buy two oil option contracts at a price of exactly 2,400 USD (2*2.1*1,000 USD), which represents 2000 barrels of crude oil. However, it is worth noting that the lower price of the option will be reflected in the currency of the option.
  • In contrast to futures positions, long call/put options are not margin positions; therefore, they do not require any initial or maintenance margin and will not trigger a margin call. This in turn enables traders with long options positions to better withstand price fluctuations without any additional liquidity requirements. Traders must have sufficient liquidity to support short-term price fluctuations. Long-term option contracts help avoid this situation.
  • Traders have the opportunity to collect a premium by selling (and therefore taking high risk) crude oil options. If traders do not want crude oil prices to change drastically in any direction (up or down), oil options create opportunities for them to make profits by selling (selling) out-of-the-money oil options. Recall that short option positions charge a premium and take risks. Therefore, out-of-sale options, whether it is a call option or a put option, will enable them to profit from the premium collection when the option is ultimately out of the money. futures Contracts do not essentially include any advance payments, so they do not provide traders with such opportunities.

Bottom line

Traders seeking downside protection in crude oil trading may wish to trade crude oil options that are primarily traded on NYMEX. In return for paying a premium in advance, oil option holders receive a non-linear risk/reward that is not normally provided by futures contracts. In addition, long options traders will not face margin calls that require traders to have sufficient liquidity to support their positions. European options are best for traders who prefer cash settlement.

(External reference material used when researching this article: Oilprice.com, Option Guide)

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