How To Cash In On Oil Using Options

June 15, 2010 | By More

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…

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.

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Category: Options Trading

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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