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Oil Futures Trading 101

Oil Rigs

When contributing to these pages I generally start from the assumption that anybody reading my ramblings is already an active trader, or at least a self directed investor, and therefore understands the basics of trading and investing in the energy markets. A reader recently contacted me, however, and informed me in no uncertain terms that that is not always the case. He said that he had subscribed here to learn about the energy markets and that my arrogance in assuming a certain degree of knowledge had become frustrating. He was nice enough to point out that I had got a few things right during his subscription but the problem was that he really had no idea how to trade the ideas. So, with that reader in mind I thought I would take the time to go over the basics of the way to play a view on oil prices, the futures market.

Assuming that you have a view on the price of oil, the simplest way to profit from that is through futures. Buying and selling physical barrels of oil is obviously not a practical proposition but betting on price fluctuations through futures is as close as you can get.

The market started as a hedging mechanism for both buyers and sellers of commodities, allowing them to lock in a known price for future transactions. The market is traded in “contracts”, each of which represents a specified number of barrels of oil. Contracts have different expiration dates on which physical settlement was originally made. By far the greatest volume of trades now though are in “non-deliverable” contracts, which reflect the current price of the commodity, but are settled on price difference between where you buy and where you sell, rather than by actually delivering barrels of crude.

Traders generally use either the main NYMEX contract which has the ticker symbol CL, or a smaller version known as the E-Mini, with the ticker symbol QM. (It should be noted that on most trading platforms a prefix to the ticker to denote a futures contract is needed. On Think or Swim for example you would type /CL or /QM.) There are several differences between the two, starting with the contract size. CL represents 1,000 barrels of oil whereas QM represents only 500. As a result each one cent move in the price of oil represents $10 per contract (1000 x $0.01) in CL and only $5 per contract (500 x $0.01) in QM.

The other major difference between the two is the size of one “tick”. A tick is the amount that a contract moves at a time. CL has a one cent tick, so the price changes in penny increments, whereas QM moves two and a half cents at a time. One tick in CL therefore represents $10 per contract in profit or loss but $12.50 for CL. Despite that though, because of the smaller contract size, QM still results in lower swings in P&L as the price moves and is generally the preferred contract for smaller retail traders.

Those new to futures but with some experience in stocks often see the market as more difficult or more risky than equities, but in some ways that is not the case. Futures offer two advantages over the stock market when it comes to trading. The first is the ease with which the traded instrument can be sold short. With stocks that is a complicated and often expensive thing to do as the stock must be borrowed in order to sell it. In futures, however, because the oil underlying the contract is never delivered, selling short is just a matter of selling the contract.

Where futures trading does get more risky than stock trading is that it involves the use of leverage, but for many small traders that is the second advantage. When you trade in futures the full value of the oil will not be deducted from your account. Your broker will instead deduct a “margin”, an amount per contract that is set by the exchange on which the contract is traded and represents insurance against possible losses. Buying or selling one contract in QM, for example will currently cost you just under $1500 in margin. Because a one cent move on that contract results in $5 of P&L you can see that a three cent move causes a 1% loss or profit, whereas it is a move of only 0.0625% at current prices.

That leverage means that risk control is of paramount importance when trading futures. Stop losses should be set in advance and stuck to or losses can quickly get out of hand. With that proviso, though, anybody who is interested in the energy markets should look seriously at futures trading. It is a fairly simple, and, if managed correctly, relatively inexpensive way of trading a view on oil price movements.

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