The Energy Opportunity for New Option Sellers

March 06, 2009

Name: James Cordier & Michael Gross

Company: Liberty Trading Group

Years Trading: 25

NA: NA

Isn't it time you learned a strategy that can profit regardless of market direction?

Everybody knows the high odds associated with selling options. The problem is most investors don’t know how to harness it effectively. OptionSellers.com has established itself as the place to be for investors seeking option selling expertise.

Request the Option Seller Information Kit

Peel away the thick outer shell of the current, aptly named “economic crisis” and underneath, you will find another related yet separate malady – a good old fashioned recession. In recessions, domestic and/or global GDP’s contract. Demand for goods and services tend to decline. Prices tend to follow as they reflect this reduced demand.

It’s not rocket science. It’s economics 101 and quite simple at it’s core.

For investors, however, who’s viewpoints and possibly judgments are impaired by their current holdings or over-analyzation, this is often a time for handwringing or worse, decision paralysis. Do you bail out of everything, sit in cash and hope the dollar doesn’t depreciate? Do you swallow hard and buy stocks, hoping you are getting a “value” and that things will turn around soon? Do you buy gold bullion and stash it in your basement?

Or, instead of making decisions about what you hope will happen in the future, why not take advantage of the way things are right now. Instead of trying to predict what will happen in the future, is there a way to invest where one can profit simply by deciding on something that probably won’t happen and investing your money in that?

The answer of course, as many of our clients and readers already know is, yes. The strategy is selling options and it can work just as well, in boring, stagnant, uninspiring markets as it does in headline grabbing, trending super performers.

As many markets are currently in the latter column, we will focus our attention on one sector that could provide a cash cow for investors insightful enough to look for a way to actually make money from the current state of the investment world.

What we are referring to is the energy markets.

Investing in the “Crack” Spread for the Individual Investor

If you are new or inexperienced in commodities, the Crack Spread may sound like something that takes place down on the bad side of town. Many investors have heard it referred to in investment media, but given little thought on how to profit from it. Today, you’re going to learn not only what it is, but how to put it in your portfolio and make it work for you – right now, in existing market conditions.

The Crack Spread refers to the price differential between crude oil and its products, (The Gasoline vs. Crude spread is highlighted during driving season, the Heating Oil vs. Crude spread is highlighted during heating season).

Crack Spreads, Oil, Selling Options; it all sounds pretty exotic for the individual investor used to deciding where to buy Microsoft. Maybe so, but the recent devaluation of so many asset classes has triggered a wave of investors learning about and flocking to alternatives. Crude oil futures and options are traded at the NYMEX in New York and have been for decades by the more sophisticated investment class. It is only a matter of learning about it and teaming with a qualified professional to make it work in your own portfolio. To learn how best to position, a focus on the fundamentals of the individual commodity is the first and most important priority. Unlike stocks, commodities will always have a value, will always have some kind of demand and are much less subject to price manipulation or corporate decisions for their price direction.

Current Fundamentals of Crude Oil

If one were seeking a poster child for markets suffering plunging demand resulting from global recession, one need look no further than Crude Oil.

Total petroleum consumption in the US declined by approximately 5.8% in 2008. This consisted of a 3.4% drop in gasoline demand and a 5.4% drop in distillate (Heating Oil and Diesel) demand. Distillates are used more in an industrial capacity and have seen a higher rate of decline as commercial demand for these products scales back.

On the supply side, decreased demand for petroleum products (gasoline and distillates) has allowed inventories of crude oil to accumulate. As of the latest EIA report, oil stocks in the US stood at 350.8 million barrels, nearly a 16 year high and 18% above the levels seen last year at this time.

2009 is not offering much hope to energy bulls. Total US petroleum consumption is expected to fall by another 2.4% this year. The EIA expects this to contribute heavily to another drop in global crude oil demand in 2009 of nearly 1.2 million barrels per day. This would be the largest drop since 1982.

The EIA is projected the price of West Texas Intermediate crude oil to average $43 per barrel in 2009.
Demand is declining, inventories are building and the top government energy agency in the US is projecting price averages of $43 per barrel.

Does selling call options at strikes nearly twice this projected level sound like a high probability investment? I’ll let you answer that.

For those unfamiliar with the option selling approach, here is how it works. Lets suppose July crude oil at the NYMEX is trading at $48 per barrel. An investor sells a July call option at a strike price of $85 per barrel. For doing this, he receives a premium of roughly $500. Now this option can fluctuate in value. However, if the price of crude oil does not reach the $85 by the option’s expiration date (late June), this option will expire worthless and the investor will keep the $500 as profit. That’s it. Not enough action for you? So sorry. It’s boring and high probability investing. Do you want action or returns? If $500 doesn’t sound like much to you, then sell 10, 20 or 100 options. It’s all up to you as to how much money you are working with and how much you are willing to risk.

If the price rose above $85 per barrel, your losses would accrue dollar for dollar with the futures contract – if you chose not to exit the position.

Of course selling options entails a bit more detail than can be described in one paragraph. However, the above example illustrates the general concept. For a more detailed explanation of the option selling approach, feel free to visit our website at www.OptionSellers.com.

Selling call options in crude oil then, appears to be a strategy worth pursuing at this time. However, if one wants to increase collected premium while potentially reducing risk, there is an additional step one can take.

Selling Options and the Crack Spread

As we discussed earlier, the crack spread is the price difference between unleaded gasoline and crude oil. When we looked at demand, we saw unleaded gasoline demand falling, but falling less than distillates. This suggests that retail gasoline demand seems to be less elastic than industrial and consumer demand for distillate. Refineries scaling back on production of both has indeed allowed crude stocks to build. But it has also had the effect of shrinking excess gasoline stockpiles. While US gasoline demand has declined overall, it remains near the same levels it was last year at this time and nearly 1 million barrels per day above the 17 year average. Yet US gasoline stocks are now 1.3% lower than last year at this time, the year gasoline raced to an all time high. More interesting perhaps, is the fact that over the past four weeks, gasoline demand in the US is up 2.2% over this same period last year.

We are not suggesting gasoline is heading to new highs by any means. However, we are suggesting that it is fundamentally stronger than both crude and heating oil and should outperform should energy prices (as a whole) move higher and be better supported should energy prices turn lower again. Unleaded gasoline is also benefiting from the seasonal tendency of wholesalers accumulating inventory as they prepare for summer driving season – a phenomenon often coinciding with price strength in unleaded.

Energy prices are getting some support simply from the fact that prices are already “low” and the possibility that demand reductions have been somewhat priced into the market. In addition, emerging economies such as China and Latin America have seen signs of life in their economies and could even see some upticks in gasoline demand this year. These factors could ad support to energy prices.

Therefore, why not sell the call on the most fundamentally bearish member of the complex (crude) and sell the put on the most fundamentally bullish (unleaded)?

With June Gasoline (RBOB) trading at nearly 1.30, one could sell the June 0.90 put and collect roughly $800 in premium.

If the complex moves lower as a whole, the profits from the crude call will help offset any temporary losses in the gasoline put. The reverse would be true if the complex moves higher as a whole.

Based on current demand figures and EIA average price estimates, Liberty Trading expects energy prices to continue to drift in somewhat of a defined range with July crude staying between $35 and $60 per barrel through the first half of 2009. Gasoline should most likely show a similar pattern albeit with a slightly upward bias. We expect NYMEX June gasoline to trade above 1.20 and below 1.60 through expiration.

While these may sound like slightly wide ranges, they are realistic and all we need to sell options effectively.
To the uninitiated, this may sound like a complex way to beat the “bear market blues” in equities. But with professional assistance, your portfolio can be positioned in these alternative investments that will not require a near term “recovery” to be successful.

If you would like more information on selling options or accounts with Liberty Trading Group/OptionSellers.com, feel free to call us at 800-346-1949 or visit us online at www.OptionSellers.com to request a free Investors Information Pack. Starter accounts are available for as little as $50,000.

About the Author

James Cordier is president and head trader of Liberty Trading Group in Tampa, Florida. With over 25 years of option trading experience, he is quoted regularly on the futures markets in several national and international publications and news services including the Wall Street Journal, Barrons, Bloomberg World News and the BBC. James’ published articles on option writing have appeared in Futures Magazine (US), Energy Risk (UK), Your Trading Edge (Australia) and MoneyWorks Magazine (Dubai).

Mr. Cordier and his firm specialize in option writing and have developed a strategy of selling out of the money options on futures contracts that they share with clients of their brokerage. Cordier’s book, The Complete Guide to Option Selling (McGraw-Hill 2005) has inspired a generation of investors, was released in China in 2007 and is scheduled for re-release in a second edition later in 2009.

James' study of the commodities market began at age 14 when a silver coin collection sparked his interest in silver futures. He began his career at Heinold Commodities in Milwaukee as a broker in 1984. Several years of working with commercial business enabled him to not only build a solid knowledge base of market fundamentals but also establish of network of producers and end users that remains in place today.

In 1991 James began an eight year association with Allendale, Inc. in Chicago where he began publication of his newsletter, the Cordier Report. Success at Allendale eventually led to his own branch office in St. Petersburg, FL.

In 1999, having established a solid reputation and a certain level of notoriety within the industry, James founded Liberty Trading Group.

Despite giving market commentary to news outlets and financial websites and co-authoring The Complete Guide to Option Selling (Mcgraw Hill 2005), James still works directly with most client equity and never underestimates the importance of staying in close contact with his clientele’ on an individual basis.