How To Cash In On Oil Using Options
The Dynamic Wealth Report
June 15, 2010
by Jay Chernoff, Editor
There’s a great opportunity in oil right now, but you may not realize
it. With the media focusing on the BP oil spill and the scary economic
conditions, it might not be obvious. Oil prices are undervalued and
there’s money to be made off of the market’s mispricing.
Take a look at the PowerShares DB Oil Fund (DBO). DBO is a widely used
ETF for trading oil. It closely tracks crude oil’s price movement.
DBO has traded in a fairly tight range ever since it came crashing down
from its highs in the summer of 2008. Back during crude oil’s record
surge, it traded as high as $55.01 on July 14th, 2008. But then, as the
full impact of the economic crisis hit the oil market, DBO plunged. It
traded as low as $15.83 on February 18th, 2009.
Oil prices are influenced by many things…
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Economic Drivers
Keep in mind, the economy directly impacts the price of oil. Greater
quantities of oil are used during more prosperous times. As the consumer
demands more oil, the price goes up. The opposite occurs during economic
downturns.
But it’s not just the economy impacting oil prices…
Seasonal Drivers
Typically, the price of oil increases as the summer months set in. More
oil is used for fuel during these active travel and vacation months. By
the time summer is in full swing, families will be piling into their
cars and headed to airports or their favorite road trip destinations.
In other words, the price of DBO should be going up – but it hasn’t.
Here’s why.
First, the BP oil spill is negatively impacting all things oil. Oil
prices, oil companies, deep sea drilling equipment companies, and
exploration & development companies are just a few of the sub sectors
showing depressed prices. Is it possible that oil prices are being
unfairly lumped in with those truly responsible for the spill?
Second, fear of a “double dip” recession is scaring off investors from
oil related products. If the economy takes a turn for the worse,
consumers are less likely to travel or go on vacations.
But what most people are missing… oil prices are ready for a rebound.
Look – the BP disaster is obviously a terrible thing. However,
fundamentally it shouldn’t be impacting the price of oil this severely.
Everything oil related has taken a hit from the spill, from the spot
price of oil to distributors to equipment companies. But… only the
companies with actual liability from the accident should be seeing the
negative effects. The price of oil simply shouldn’t be suffering
collateral damage from the spill.
Actually, if you think about it, the BP disaster should increase the
price of oil. Thousands of gallons of oil are going to waste. Not to
mention the government ban on deep sea drilling which will be in place
for several more months. Basically, it means the oil supply is going to
decrease. As supply decreases, oil prices will go up.
But that’s not all…
Demand should also increase as the economy improves. The fears of a
“double dip” recession have been receding in recent days as positive
economic news continues to trickle in. Consumer confidence and pending
home sales are two key indicators which recently beat expectations.
Emerging markets are also showing signs of growth. Important indicators
such as industrial production are on the rise in key markets such as
China and India.
I’m not suggesting oil’s about to hit record highs any time soon… but I
do believe we’ll see a rally in DBO during the summer months as demand
for oil increases.
So how can we maximize the opportunity in this ETF? I think the best way
to grab the biggest gains is by purchasing October 25 calls on DBO.
Using the October expiration gives us time for oil prices to recover. And, it means expiration won’t occur until after summer is over. I like
the 25 strike because it’s trading at a reasonable price of around $2.00
an option. It means we’ll start making profits once DBO climbs above
$27.00 (25 strike price plus $2.00 options price).
Buying a $2.00 option will cost you $200, not including commissions. Here’s the thing… $200 is a small price compared to what you’d pay to
own the ETF outright. See, owning a call is the equivalent to
controlling 100 shares of DBO. However, 100 DBO shares would cost you
almost $2,500!
By purchasing the call, you’re spending 8% of the cost of owning the
shares.
If you think oil is about to jump in value, consider buying October
calls on DBO. The ETF should see gains from several drivers including
economic growth and seasonal price increases. Using options is a great
way to increase your profit potential while limiting your risk.
Last week was quiet in the IPO market with only one new offering to
report. China New Borun Corporation (BORN) began trading last Friday. It
initially traded at its opening price of $7 a share. Now just a few days
later, the stock has dropped $0.50 or 7%. Not a good start for an IPO.
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