Question

There is a critical meeting where OPEC members are going to discuss whether to reduce of increase oil supply. Current price of oil is $77. Use put and call options to design a strategy profitable in case of possible big positive and negative price swings.

Answer 1

As per given case Crude current Price is $77/barrel now we all know there is a very high volatility in crude oil market. And it affects the nation economy. There is a possibility to go for derivative deal for underlying assets for crude oil price. We can also enter in Option Put & Call option which can give rights but not an obligation to fulfil the deal.

Options are divided into two classes - calls and puts. Crude Oil call options are purchased by traders who are bullish about crude oil prices. Traders who believe that crude oil prices will fall can buy crude oil put options instead.

Buying calls or puts is not the only way to trade options. Option selling is a popular strategy used by many professional option traders. More complex option trading strategies, also known as spreads, can also be constructed by simultaneously buying and selling options.

By exercising your call option now, you get to assume a long position in the underlying crude oil futures at the strike price of USD 40.00. This means that you get to buy the underlying crude oil at only USD 77.00/barrel on delivery day.

A NYMEX Crude Oil call option with the same expiration month and a nearby strike price of USD 40.00 is being priced at USD 2.6900/barrel. Since each underlying NYMEX Light Sweet Crude Oil futures contract represents 1000 barrels of crude oil, the premium you need to pay to own the call option is USD 2,690.

To take profit, you enter an offsetting short futures position in one contract of the underlying crude oil futures at the market price of USD 83.34 per barrel, resulting in a gain of USD 6.3400/barrel. Since each NYMEX Light Sweet Crude Oil call option covers 1000 barrels of crude oil, gain from the long call position is USD 6,340. Deducting the initial premium of USD 2,690 you paid to buy the call option, your net profit from the long call strategy will come to USD 3,650.

Long Crude Oil Call Option Strategy
Gain from Option Exercise	=	(Market Price of Underlying Futures - Option Strike Price) x Contract Size
	=	(USD 46.34/barrel - USD 40.00/barrel) x 1000 barrel
	=	USD 6,340
Investment	=	Initial Premium Paid
	=	USD 2,690
Net Profit	=	Gain from Option Exercise - Investment
	=	USD 6,340 - USD 2,690
	=	USD 3,650
Return on Investment	=	136%

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, 2017, a trader named Helen takes a long call position on February 2018 American crude oil options. The futures strike price is $90 per barrel. On November 1, 2017, the February 2018 futures price is $96 per barrel; Helen wants to exercise her call options. By exercising the options, she enters into a long February 2018 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.

For instance, assume that on September 25, 2017, Helen the trader enters into a long call position in European crude oil options on February 2018 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, 2017, 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).