Oil Discovery: Options for Short-Term Income Trades

Good news, oil mavens!

Oil’s up, with crude oil futures gaining 35% from the low in March through late April. The bad news, of course, is that levels are still 48% lower than a year ago. But for option traders seeking short-term income trades, oil options might offer some potential. Let’s take a closer look.

This recent rally in oil prices (figure 1), not surprisingly, has dampened option implied volatility levels. So, although they’re not at those nose-bleed levels the market saw at the beginning of the year, option premiums are still relatively high.

With high volatility, selling options (or out-of-the-money spreads) is the first thing that comes to mind. But consider this bit of conventional wisdom: Don’t sell options just because volatility is high.

Sell only when you expect the option price to drop. So what makes an option, or OTM spread, drop in value and set up a potential profit? Any of the following scenarios:

• Time passes
• Implied volatility drops
• Stock moves the right way

The first of these is certain. Selling high-volatility options just means those options have to decay prior to expiration, which means that if a trader believes the option volatility will drop, that might be reason enough to sell a spread.

And, of course, if you have an opinion about oil’s direction, short spreads might be the way to go.

Let’s dive in a bit deeper. Selling Cash-Secured Puts Working with a fictional oil stock trading at $40, here’s an example of a cash-secured put. You might consider selling to open (going short) the 37-strike put, which means you’re taking on the obligation of potentially having to buy the stock at $37, which is 7.5% lower than where it’s currently trading.

You also collect $1 in premium from the sale of the option, so really, your total risk is now $36, plus commissions and fees. If the stock remains above $37 at expiration, then the option expires worthless and the $1 premium is all yours, minus commissions and fees.

Selling OTM Call Spreads

Another potential idea is selling an option spread. Instead of just selling an out-of-the-money option you think will expire worthless, you also buy an even further OTM option as insurance against a big move. You still collect a net credit on the trade while limiting your exposure and potentially reducing your capital requirements on the trade.

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Put It All Together

Consider selling OTM put spreads if you think oil prices won’t tank. Sell OTM call spreads if you doubt oil’s going to continue its rebound. Or you can sell them both at the same time and end up with a more complex trade called an iron condor if you think oil will hold in a range. Keep in mind that if your view of volatility or price movement is wrong, then short options can go up in value, putting you at risk of potentially paying more for the option than what you collected from the sale.

So which do you choose?

Once you think option prices will drop, pick your strategy. Just remember, time always works in your favor with short options and short OTM spreads. It’s the other two—volatility and stock movement—that you have to keep an eye on.

This piece was originally posted here by Greg Loehr on May 7, 2015.

Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return.

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