Other Voices: A 'Trade War' Option Play On Crude

Investors Alley's Jay Soloff discusses a simple option trade to create an income stream off oil

By Jay Soloff

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The escalation of the trade war between the United States and China is having far reaching effects on the financial markets. Tensions between the world’s two biggest economies is causing an increase of market volatility and a shift of assets into safe-haven investments like bonds and gold.

The actual trade of goods between China and the United States doesn’t amount to nearly as much money (as a percentage of GDP) as many have been led to believe. However, the disruption in the global supply chain is a big deal to many companies in both countries who rely on each other for goods and labor.

What’s more, the markets never like uncertainty. Any sort of disruption to the normal flow of business can often cause concern among investors. And when investors start to worry, they are much more likely to park their funds in something like fixed income products.

Of course, if money is flowing into bonds, then it must be flowing out of stocks and other assets deemed more risky. That’s why we’ve been seeing semi-frequent stock selloffs anytime bad news about the trade war hits the headlines.

It’s been even worse recently for crude oil. Not only is oil impacted on the demand side due to the trade war. (Less trade between international partners means less demand for oil.) But, crude is also dealing with an unexpected glut in inventories.  

The double-whammy of low demand/high supply caused the price of crude to drop 5% in one day last week. Over the last month, crude oil prices are down over 12% to roughly $58 per barrel.

However, a well-capitalized strategist is betting on crude to at least hold its ground over the next two months.  The trader used the United States Oil Fund (USO) for this position. USO is the most popular ETF for trading crude oil. It trades crude oil futures and does not invest in oil-related companies, so it’s mostly a pure play on oil prices.

The neutral to slightly bullish trade made by this strategist was a covered call on USO shares. More precisely, the trader bought 1 million shares of USO and sold 10,000 July 13-strike calls against the shares. At the time of the trade, USO was trading for $12.10.

The calls were sold for $0.28, which amounts to $280,000 dollars. That may not seem like much but over the course of just 2 months, it equates to a 2.3% yield, or almost 14% annually. Plus the 28 cents provides a measure of downside cushion for the long shares.

In addition, the calls were sold at the 13 strike so there is the potential for USO to gain $0.90 before the upside gain is capped. That’s an additional 7.4% of stock appreciation that can be earned. If USO is at $13 or above by July expiration, the position can return 9.7%… certainly not bad for just 2 months.

A large trade like this (remember, the position involved buying 1 million shares) suggests that crude oil may be limited in how far it can fall. Perhaps the strategist feels the bad news is now all built in to the price and it’s either going sideways or up from here (but not too far up).

Finally, this would be a very simple position to put on in your own account if you believe oil isn’t going to continue falling. Even if you’re not very bullish on crude, the additional income could be a nice boost to your portfolio over the coming couple months.

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