How To Buy Oil Options

Crude oil options are the most widely traded energy derivative on the New York Mercantile Exchange (NYMEX), one of the largest derivative product markets in the world. The underlying asset for these options is not actually crude oil itself, but rather crude oil futures contracts. Thus, despite the name, crude oil options are in fact options on futures.

Both American and European types of options are available on NYMEX. American options, which allow the holder to exercise the option at any time over its maturity, are exercised into underlying futures contracts. For instance, a trader exercising American crude oil call options takes a long position in the underlying crude oil futures contract. Conversely, exercising crude oil put options means taking a short futures position.

Call Option Payoffs

The table below summarizes the American option positions that, once exercised, result in underlying futures positions shown in the second column.

Example with American Calls

For example, let’s assume that on Sept. 27, 2021, a trader named Helen bought American-style call options on April 2022 crude oil futures. The options strike price is $90 per barrel. On Nov. 1, 2021, the April 2022 futures price is $96 per barrel; Helen wants to exerwcise her call options. By exercising the options, she enters into a long April 2022 futures position at the locked-in price of $90. She may choose to wait until expiration and take the delivery of physical crude oil underlying the futures contract, or else close the futures position immediately to lock in $6 ($96 – $90) per barrel. Considering the contract size on one crude oil option is 1,000 barrels, the $6 per barrel would be multiplied by 1000, yielding a $6,000 payoff from the position.

Example with European Calls

European-style oil options are settled in cash. Note that, in contrast with American-style options, European-style options may only be exercised on the expiration date. On the expiration of an in-the-money call option, its value will be the difference between the settlement price of the underlying crude oil futures and the option strike price multiplied by 1,000 barrels. Conversely, an in-the-money put option will be worth the difference between the option strike price and the underlying futures settlement price, multiplied by 1,000, at expiration.

For instance, assume that on Sept. 27, 2021, trader Helen buys European-style call options on April 2022 crude oil futures at a strike price of $95 per barrel, and that the option costs $3.10 per barrel. Crude oil futures contract units are 1,000 barrels of crude oil. On Nov. 1, 2021, the April 2022 crude oil futures price is $100 per barrel and Helen wishes to exercise the options. Once she does this, she receives ($100 – $95)*1000 = $5,000 as payoff on the option. To calculate the net profit for the position, we need to subtract the cost of options (the option premium paid to the seller) of $3,100 ($3.1*1000). Thus, the net profit on the option position is $1,900 ($5,000 – $3,100).

Oil Options Vs. Oil Futures

Options contracts give purchasers the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at a preset strike price. The most a crude oil option holder can lose is the cost paid for the option, rather than the cost of the underlying futures contract. Futures contracts require more capital for a given level of exposure relative to options and do not have options' asymmetric return characteristics.

Oil options do not require physical delivery at expiration, as is the case with some (but not all) crude oil futures contracts. European-style oil options are cash settled, providing cash payouts to holders of in-the-money options at expiration. In contrast, crude oil futures traded on the NYMEX require delivery at expiration. The trader short one futures contract must deliver 1,000 barrels of crude oil at the specified delivery point, while those with a long position must accept delivery.

Where the initial margin requirement of futures is higher than the premium required for the option on a comparable exposure, option positions provide more leverage. For example, imagine that NYMEX requires $2,400 as an initial margin for one crude oil futures contract that has 1,000 barrels of crude oil as the underlying asset. An option on that futures contract might cost $1.20 per barrel. A trader considering those alternatives could buy two oil option contracts that would cost exactly $2,400 (2*$1.20*1,000) and represent 2,000 barrels of crude oil. It is worth noting, however, that the inherent leverage of options will be reflected in the option price.

In contrast to crude oil futures, the long call/put crude oil options are not margin positions; thus, they do not require any initial or maintenance margin, and would not trigger a margin call. This helps the long option position trader wait out price fluctuations. The futures trader may need to provide additional capital should their margined positions lose value. Long option contracts help to avoid this.

Traders have the opportunity to collect premiums by selling crude oil options (and assuming the inherently much higher risk of short option positions). For traders who expect rangebound prices, crude oil options can provide an opportunity to earn a premium by writing (selling) out-of-the-money options. Recall that a short option position collects the premium and assumes the risk. Selling out-of-the-money options, be they calls or puts, may enable the seller to retain the premium should the option expire out-of-the-money. Futures contracts do not provide a similar opportunity.

The Bottom Line

Traders who seek to increase leverage or secure an asymmetric return profile may choose to trade crude oil options on the NYMEX or another exchange. In return for a premium paid upfront, oil option holders obtain a non-linear risk/return profile not available in futures contracts. Additionally, long options traders do not face margin calls that might require future traders to provide additional margin capital for a devalued position. European-style options are optimal for traders who prefer cash settlements.