Beyond the Oil Patch: Basics of Crude Oil Futures & Options

Beyond the Oil Patch: Basics of Crude Oil Futures & Options

Key Takeaways

    Crude oil futures and options offer exposure to the world’s most actively traded commodity

    WTI and Brent crude are the global oil benchmarks and the basis for the biggest oil futures contracts

    Weekly crude options linked to oil futures can offer greater flexibility to respond to oil-related news

Since the dawn of the Industrial Revolution, crude oil has powered the engine of the global economy. There’s nothing unsophisticated about the various angles professional investors and traders take to get a piece of the world’s most actively traded commodity—the list includes energy stocks and bonds issued by companies in the energy sector, as well as energy sector ETFs and options contracts on listed stocks and ETFs.

Individual investors and traders can also venture beyond publicly traded energy companies and gain inroads to the oil patch through futures and options-on-futures markets—including some relatively new futures-linked products called weekly crude options (more below).

Why invest in oil? The oil market is as global as they get, and it’s in the news every day. Sometimes crude oil prices can be volatile. Traders and investors might look for opportunities to protect portfolios—or seek diversification—and to potentially capitalize on short-term events. So let’s take a look at some basics for investors on crude oil markets.

And for qualified TD Ameritrade account owners, there’s a new option on the thinkorswim® platform—literally—in the form of weekly options on crude oil futures.

Global Oil Benchmarks: Get to Know WTI and Brent Crude

Futures contracts are standardized agreements between buyers and sellers where both parties agree to buy or sell a specific amount of a particular commodity at a predetermined price at a specific date in the future.

The biggest oil futures markets, such as CME Group (CME), trade contracts based on West Texas Intermediate crude (WTI, the U.S. benchmark) or Brent crude (based on oil pumped out of the North Sea near Norway and the UK). One CME WTI crude oil futures contract (/CL) specifies 1,000 barrels for delivery in Cushing, Oklahoma, a large storage hub near some of the biggest U.S. oil fields.

Brent crude’s primary exchange is the Intercontinental Exchange (ICE), but CME also lists a Brent contract (symbol /BZ on the thinkorswim platform).

Light and Sweet Crude, or Heavy and Sour?

Crude that’s called “light” is relatively low-density oil and considered easier to refine into gasoline and other petroleum products versus a “heavy” oil. “Sweet” and “sour” refer to an oil grade’s sulfur content.

Crude with sulfur content under 0.5% is considered sweet (and also easier to refine). WTI and Brent crude futures contracts are both based on light, sweet grades. Although WTI and Brent crude prices usually differ by a few dollars, the two grades are highly correlated and often rise or fall together. Still, supply disruptions or other fundamental developments may affect one grade more than the other, which can cause WTI and Brent prices to diverge.

Meet the Major Futures Players: Commercials and Speculators

There are two broad types of oil futures market participants. One group, the hedgers, or “commercials,” is in the business of exploration, drilling, refining, shipping, or selling crude oil or refined products. Hedgers might include major oil and gas producers, independent refiners, or retail fuel chains that use futures to try to insulate themselves against adverse swings in oil prices or to lock in supplies.

Another main group, the speculators, or “specs,” can include banks, hedge funds, and individuals who trade commodities for a living. They speculate that the price of oil, natural gas, or refined products such as gasoline will go up or down within a certain time frame.

Futures Markets Are Different from Stocks

For traders who are willing to take a more active approach to portfolio strategy, futures can present opportunities not always available in traditional investments like equities.

Oil futures, and other commodity futures markets such as gold, are considered “alternative” investments, which sometimes behave differently from your typical stock or bond and offer diversification that could be valuable in a broad-based equity market slide.

Shares of oil production companies and others in the energy sector often follow the price of crude. In 2019, that’s been a problem for any buy-and-hold aspirations in energy stocks, as subdued crude prices (with WTI futures largely trading between $50 to $60 a barrel) had oil and gas company shares under pressure. In late November 2019, the S&P Oil & Gas Exploration & Production Select Industry Index had fallen more than 36% over the previous 12 months (see figure 1).

Beyond the Oil Patch: Basics of Crude Oil Futures & Options

FIGURE 1: CRUDELY CORROLATED. The S&P Oil & Gas Exploration & Production Select Industry Index ($SPSIOP, candlesticks) has had a rough go of it since the fall of 2018. Although the index fell the hardest concurrent with a meltdown in crude oil futures (/CL, purple line), a partial rebound in crude hasn’t helped the oil and gas industry to the degree many hoped it would. Data source: S&P Dow Jones Indices, CME Group. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Oil futures, by providing exposure to the commodity itself—rather than the companies that deal in it—could help buck the broader energy industry trend in a few different ways. For example, a qualified investor or trader could sell oil futures “short,” potentially capitalizing on a drop in crude prices, or go “long” and possibly capture gains on a short-term rally.

There are margin requirements associated with trading crude oil, which for futures trading typically requires a smaller amount than with stocks.

Initial margin requirements vary by futures product and are typically a small percentage—2% to 12%—of the notional value of the contract. (For WTI crude futures, the maintenance margin requirement in late November 2019 was about 7% of the contract’s overall value; by contrast, with equity margin trading, an investor can only borrow up to 50% of the purchase price.) Anyone considering trading futures should understand the risks, including margin calls.

New Twist on Oil Futures: Weekly Crude Options on thinkorswim

Oil markets move quickly, and there’s a lot of information to process on any given day. Surprises can and will happen. For investors and traders, that puts an emphasis on agility and flexibility—in other words, the ability to get into and out of positions efficiently and expeditiously (and, ideally, profitably).

That’s the idea behind CME Group’s Weekly Options based on WTI crude futures and other energy markets, now available on thinkorswim to qualified account owners. Weekly crude oil options, which expire every Friday at 1:30 p.m. Central time, trade similarly to the monthly versions. Keep in mind that the shorter expirations require close monitoring, and the options can be subject to significant volatility. A small movement in the underlying can have a larger impact on the option price.

All else equal, an options contract’s price (its “premium”) is lower the closer you get to its expiration date. Shorter expiration periods for the weeklies (typically four every month, as opposed to one expiration per month) open additional opportunities to hedge, play hunches, and more, according to Adam Hickerson, senior manager, futures & forex at TD Ameritrade.

Weekly crude options “enable trading in a shorter time frame, which allows you to be more responsive to news,” Hickerson said. For example, weekly oil supply reports from the U.S. Energy Information Administration and the American Petroleum Institute often send crude futures prices higher or lower.

Weekly crude options could be used to hedge an oil futures position or an oil-related equity position. Suppose an investor owns shares of an exploration and production company that he thinks is a good long-term holding, but is concerned about a possible short-term price dip. That’s another case where weekly crude options could come in handy. Crude futures often correlate with shares of energy companies, but it’s important to note that it’s not a perfect correlation (recall the periods of correlation as well as divergence in figure 1). Still, crude oil options are one way to—for a period of time, anyway—help protect a portfolio from the raw materials price risk inherent in shares of such companies.

Also, in the grand investing scheme of things, “an option is an option,” Hickerson added. “You can use the same options strategies as you would with traditional equities or futures. Now you can choose a more defined timeline for your options expiration.”

If you’re venturing into options on futures for the first time, and you’re familiar with equity options, remember to look at the contract specifications before you make that first trade. Unlike standard equity options, which all have a multiplier of 100, futures contracts come in various shapes and sizes. For more, refer to this primer on the differences between equity options and options on futures.  

The Bottom Line on Crude Oil Futures and Options

Whether you’re seeking long or short exposure, for the long term or the short term, and whether it’s to hedge or to speculate, futures and options on futures can be useful and capital-efficient additions to the trader tool set. But these products—and the margin accounts in which they’re traded—aren’t for everyone, and not all accounts will qualify. Additional education about futures, options, and margin can help you decide if such strategies are right for you.

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