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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 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 who is long on American call/put crude oil options takes long/short position on the underlying crude oil futures contract.

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

American crude oil option position

After exercise of respective crude oil options

Long call option

Long futures

Long put option

Short futures

Short call option

Short futures

Short put option

Long futures

For example, let’s assume that on September 25, 2014, a trader named Helen takes a long call position on February 2015 American crude oil options. The futures strike price is $90 per barrel. On November 1, 2014, the February 2015 futures price is $96 per barrel; Helen wants to exercise her call options. By exercising the options, she enters into a long February 2015 futures position at the price of $90. She may choose to wait until expiration and accept the delivery of the crude oil at the locked-in price of $90 per barrel, or she may close the futures position immediately to lock in $6 (=$96 – $90) per barrel. Taking into account that the contract size on one crude oil option is 1,000 barrels, the $6 per barrel would be multiplied by 1000, thus yielding a $6,000 payoff from the position.

The European type of oil options are settled in cash. Note that, contrary to American options, European options may only be exercised on the expiration date. On expiration of a call (put) option, the value will be the difference between the settlement price of the underlying Crude Oil Futures (strike price) and the strike price (settlement price of the underlying Crude Oil Futures) multiplied by 1,000 barrels, or zero, whichever is greater.

For instance, assume that on September 25, 2014, Helen the trader enters into a long call position in European crude oil options on February 2015 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 November 1, 2014, the crude oil futures price is $100/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 option costs (the premium that the long option position pays to the short option position at the beginning of the transaction) 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 holders (of long positions) the right, but not the obligation, to buy or sell (depending on whether the option is call or put) the underlying asset. Thus, options have a non-linear risk-return profile that is best for those crude oil traders who prefer downside protection. The most a crude oil option holder can lose is the cost of the option (premium) that is paid to the option writer (seller). Futures contracts, however, do not give such an opportunity to contract sides, since they a have linear risk-return profile. Futures traders can lose the entire position during an adverse movement of the underlying price.
  • Traders unwilling to bother with physical delivery, which might require a lot of paperwork and complex procedures, may prefer oil options to oil futures. More specifically, European options are cash settled, meaning that once the options are exercised, the option holder receives the positive payoff in cash. In this case, the delivery and acceptance are not an issue for the contract sides. The crude oil futures traded on NYMEX, however, are physically settled. The trader who has a short position on one futures contract must deliver 1000 barrels of crude oil at expiration, and the long position must accept the delivery.
  • Where the initial margin requirement of futures is higher than the premium required for the option on similar futures, option positions offer extra leverage by freeing some of the capital required for the initial margin. For example, imagine that NYMEX requires $2,400 as an initial margin for one February 2015 crude oil futures contract that has 1000 barrels of crude oil as the underlying asset. We can find a crude oil option on February 2015 futures that costs $1.2/barrel. Thus, a trader can buy two oil option contracts that would cost exactly $2,400 (2*$2.1*1,000) and represent 2000 barrels of crude oil. It is worth noting, however, that the lower price of the options will be reflected in the moneyness of the options.
  • In contrast to the futures position, the long call/put option positions are not margin positions; thus, they would not require any initial or maintenance margin, and furthermore would not trigger a margin call. This in turn enables the long option position trader to better sustain price fluctuations without any additional liquidity requirement. The trader must have enough liquidity to support short-term price fluctuations. Long option contracts help to avoid this.
  • Traders have the opportunity to collect premiums by selling (thus assuming high risks) crude oil options. If traders do not expect the crude oil prices to strongly change in any direction (up or down), oil options create an opportunity for them to earn a profit by writing (selling) out-of-the-money oil options. Recall that a short option position collects the premium and assumes the risk. Thus, selling out-of-the-money options, be it call or put, will enable them to profit from premium collection should the option end up out-of-the-money. Futures contracts by nature do not include any upfront payments, therefore they do not offer this type of opportunity to the traders.

The Bottom Line

Traders who seeks downside protection in crude oil trading may want to trade crude oil options that are traded mainly on the NYMEX. In return for a premium paid upfront, oil option holders obtains non-linear risk/return not normally offered by futures contracts. Additionally, long options traders do not face margin calls that require traders to have enough liquidity to support their position. European options are optimal for traders who prefer cash settlements.

(External references used in researching this piece: Oilprice.comThe Options Guide

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