Crude oil is among the most notorious commodity markets but is also among the most treacherous. Nonetheless, speculators are drawn toward the leverage and volatility provided in this trading arena...and the stories of riches made and lost by its participants.
Before risking your hard-earned money speculating in crude oil, it is important to be aware of a few details. For starters, it is possible to trade oil via ETF's that attempt to track the price of crude, through the shares of firms that are correlated to crude oil prices or by using the futures and options markets. Despite the alternatives, I believe there is only one that will provide the efficiency and the market access necessary to trade in such a global market; futures and options on futures.
The Value in Trading Crude Oil Futures
My preference for futures partly lies in the fact that I am a commodity broker, but it goes much deeper than that. Here are a few key advantages to futures over equities.
Crude futures open for trade Sunday evening at the NYMEX (New York Mercantile Exchange) and, for all intents and purposes, trade around the clock until Friday afternoon. On the contrary, ETF and Stock traders are able to execute trades during the official day session of the NYSE, and similar exchanges, as well as in the designated pre-open and after-market sessions. The entire span of trading is limited to approximately ten hours...or less.
Additionally, futures and options traders enjoy preferable tax treatment. Positions, regardless of their time span, are taxed at a 40% / 60% blend between long term and short-term capital gains. This differs from equity traders, which are taxed at the higher short-term gains rate on all positions held for less than a year.
Even more compelling; why trade an imitation when you can trade the real thing? ETF's are simply funds created to track the price of crude oil but they might not always be perfectly correlated. Similarly, energy company stocks are exposed to both market risk and company specific risk in addition to being somewhat correlated to crude prices. In other words, each of these options offer a less efficient means of profiting, or suffering losses, from speculations made.
By definition, a futures contract is a standardized, transferable, exchange traded contract that requires delivery of a specific commodity, at a specified price, and on a specified date in the future. To clarify, futures contracts are simply an agreement between the buyer and the seller; therefore, they are liabilities rather than assets. For those looking for pure speculation in crude, the futures market is the place to get it. Unlike ETF's or energy related stocks, crude oil futures traders will make or lose money in lockstep with changes in price of the underlying asset. This is made possible by the fact that crude oil itself is deliverable against the futures contract and while traders may not be exchanging physical barrels of crude, they are buying or selling agreements that represent the asset. This is as close to the real thing as you can get.
As if these arguments weren't persuasive enough, those trading crude oil in the futures markets are provided free leverage. In other words, there are no interest charges for shorting or trading on margin.
Crude Futures, or Options on Futures?
Once a trading venue is chosen, the "options" don't end there. NYMEX crude oil traders have the ability to trade a full-sized futures contract, options written on this full-sized futures, or a mini version of the futures contract.
With the exception of the mini-sized crude oil futures, crude futures and options can be executed in two separate venues; open outcry and electronic trade matching. Open outcry, or pit trading, takes place in a marked area on the trading floor of the exchange and entails the buying or selling of instruments by hand signals and shouting. It is quite exciting and can best be described as organized chaos.
Electronic trade matching doesn't have a physical location; instead, the buy and sell orders placed by traders are executed in a cyber environment with little or no human intervention. During the official day session, traders have the ability to use either venue for execution and because the contracts are fungible, it is possible to enter a positions through the pit and exit electronically.
During the day session, both arenas are available to traders but in the extended overnight session it is only possible to trade crude oil electronically.
NYMEX Light Sweet Crude Oil Futures
The original full-sized version of NYMEX crude is written with 1,000 barrels of crude oil as the underlying. Quite simply, a trader long or short a single futures contract will make or lose money based on the value of 1,000 barrels. With crude oil worth $70 per barrel, the total value of a single futures contract is $70,000 ($70 x 1,000 barrels). Keep in mind that the margin, or required good faith deposit to trade crude, fluctuates between $4,000 and $8,000. Therefore, traders can expose themselves to the price fluctuations of a contract valued at approximately $70,000 with less than 10% down. It is easy to see how quickly gains and losses can add up with this type of leverage.
With that said, although the exchanges set the required minimum margin it is the trader who ultimately controls the amount of leverage used. Those not wishing to use leverage, and the available capital, can effectively eliminate it by depositing the full value of each contract traded.
The minimum tick in crude is one penny, and equates to a profit or loss of $10 to a trader. Accordingly, a dollar in price move in the underlying results in a profit or loss of $1,000 per contract. For instance, a trader that bought crude oil at $62.00 and sold at $63.00 would have walked away from the trade a winner in the amount of $1,000 minus commissions and fees.
As mentioned, there is also a mini version of the crude oil futures contract which is exactly one half of the original. A mini contract represents 500 barrels of crude and a trader long or short in this market will make or lose $500 for every dollar in price movement. As you have probably inferred, the margin for mini crude is about half of the full-sized version and so is the volatility and market exposure.
NYMEX Crude Options
Trading outright futures entails theoretically unlimited risk, relatively high margins and immediate risk upon entry. For many small retail traders, this is a deal breaker. However, there are ways to participate in crude oil with variable levels of risk, reward and volatility through the use of options. My book, "Commodity Options", I outline several of the most popular option trading strategies and methods of adjusting them to fit the personality and goals of each trader.
Again, the NYMEX provides traders with the ability to trade options via electronic execution or open outcry. There are advantages and disadvantaged to each, but it is nice to have access to both. For instance, since the advent of electronic crude oil options, it is much easier for retail traders to access live price quotes. In addition, electronic fills are reported immediately and it is convenient to cancel and or replace existing orders. However, realize that it can often be more efficient to use open outcry execution for options because it might be possible to get smaller bid/ask spreads. If you are unfamiliar with the bid and ask, it is simply the difference between the price that you can buy a contract and the price that you can sell it. The smaller the spread, the better fills getting in and out, and the lower transaction costs faced by traders.
For those interested in trading spreads it is necessary to use the open outcry execution. Through the pit, it is possible to name a price (limit order) on a package of options (spread). In other words, orders can be placed on multiple options as an all or nothing proposition to be executed at a specific price or better. Electronic crude oil option traders must place each leg of a spread individually, often leading to partial fills or chasing prices on unfilled legs. For reasons mentioned, it is a good idea to have access to a commodity broker who, in turn, has direct access to specialists on the exchange floor.
Keep in mind that trading with a broker that has direct access to option specialists on the floor will likely cost you a bit more in commission and fees relative to placing your order on a self-directed basis through an online trading platform. After all, they don't work for free. However, if using this method of execution can save you a single tick in the fill price it will have likely more than paid for the incremental costs; if they can save you a few ticks you will actually save money. Don't trip over dollars chasing pennies!
*Futures and Options Trade Involves Substantial Risk of Loss and is Not Suitable for All Investors.
Carley Garner is the author of "Commodity Options" and Senior Analyst at DeCarley Trading LLC where she also works as a broker. Visit www.DeCarleyTrading.com for your free trial subscription to Carley's e-newsletters and for details on the services she provides. Her next book, "A Traders First Book on Commodities" will be available in February 2010.