Crude oil options are the most widely traded energy derivatives on the New York Mercantile Exchange (NYMEX), which is one of the largest derivative product markets in the world. An important point to note is that the underlying asset is not crude oil itself. Rather, they are crude oil futures contracts. Despite the name, crude oil options are options on futures. In this article, we look at what they are and how to buy these complex assets.
- Hedgers and speculators can use options in the oil market to gain the right to purchase or sell crude futures at a set price before their options expire.
- Options do not have to be exercised on expiration, giving the contract holder more flexibility.
- Oil options come in American and European varieties and trade in the U.S. on the NYMEX exchange as well as on the ICE and CME exchanges.
What Are Crude Oil Options?
An option is a financial contract that is based on the value of an underlying asset. It gives purchasers the right but not the obligation to buy (call option) or sell (put option) the underlying asset at a preset strike price by an expiration date. In most cases, crude oil options do not require physical delivery at expiration. As such, the most a crude oil option holder can lose is the cost paid for the option.
Traders may 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 may allow them to earn a premium by selling out-of-the-money (OTM) options. Recall that a short option position collects the premium and assumes the risk. Selling OTM call or put options may enable the seller to keep the premium if the option expires OTM.
Long call/put crude oil options are not margin positions. This means 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.
American vs. European Oil Options
Options come in different forms. How they’re categorized is based on their exercise restrictions. Two of the most common types are American and European options—both of which are available to trade on NYMEX.
American options allow the holder to exercise the option at any time over its maturity. They are exercised into underlying futures contracts. A trader who exercises American crude oil call options takes a long position in the underlying crude oil futures contract. Exercising crude oil put options means taking a short futures position.
European-style oil options can’t be settled before the contract expires, which makes them less flexible than American ones. These options are cash-settled. As such, they provide cash payouts to holders of in-the-money (ITM) options at expiration.
When a European call option expires ITM, its value is the difference between the settlement price of the underlying futures and the option strike price multiplied by 1,000 barrels. Conversely, an ITM put option will be worth the difference between the option strike price and the underlying futures settlement price, multiplied by 1,000, at expiration.
Call Option Payoffs
The table below summarizes the American option positions that, once exercised, result in underlying futures positions shown in the second column.
|American Crude Oil Option Position
|After Exercise of Respective Crude Oil Options
|Long call option
|Long put option
|Short call option
|Short put option
Crude Oil Options vs. Crude Oil Futures
Crude oil options are different than another complex financial instrument: crude oil futures. Futures contracts require more capital for a given level of exposure relative to options and do not have options’ asymmetric return characteristics. Unlike options, some (but not all) crude oil futures contracts require physical delivery of the underlying asset when the contract expires.
Crude oil futures are the most actively traded commodity futures, according to Charles Schwab. Traded on NYMEX, they 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 x $1.20 x 1,000) and represent 2,000 barrels of crude oil. However, it is worth noting that the inherent leverage of options will be reflected in the option price.
Examples of Crude Oil Options
American Call Options
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 decides that she wants to exercise 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 the contract expires 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.
European Call Options
Let’s say that on Sept. 27, 2021, 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. On Nov. 1, 2021, the April 2022 crude oil futures price is $100 per barrel.
Helen wishes to exercise the options. Once she does this, she receives $5,000 (($100 – $95) x 1000) as a 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 x 1000). Thus, the net profit on the option position is $1,900 ($5,000 – $3,100).
How Do You Trade Crude Oil Options?
If you want to know how to trade options, it’s a good idea to learn how they work. Options are financial contracts where the buyer has the right (not the obligation) to buy or sell the underlying asset at a predetermined price by the expiry date. With crude oil options, the underlying asset is crude oil. Once you understand the basics of the fundamentals of oil, choose the brokerage firm where you’ll open an account and begin trading. Decide which type of option you’ll trade, then pick your strike price (the price at which the contract will be set) and the expiry date.
What’s the Difference Between Call and Put Options?
A call option gives the trader the right (but not the obligation) to buy the underlying asset at the specified price by the expiry date. The trader of a call option pays a premium for the contract. They look for a rise in the price of the underlying asset and gains are unlimited.
A put option, on the other hand, gives the trader the right (but not the obligation) to sell the underlying asset at the predetermined price when the contract expires. Like a call option, the trader pays a premium for a put contract but, in this case, the trader hopes for a drop in the price. Gains realized in put options, though, are limited.
What Are Bermuda Options?
Bermuda options are similar to American and European options—all of which rely on the price of an underlying asset. All three allow the trader to buy or sell the underlying asset at a predetermined price. But with the Bermuda option, the trader can only do so on certain dates before or on the contract’s expiry date.
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.