The Risks and Rewards of Investing in Crude Futures

Trading crude oil futures uses a high degree of leverage. It is possible for those who trade crude oil futures to make and lose substantial amounts of money in a very short period of time. The price of crude oil is notorious for its volatility. It can easily move 5 to 10% in a single trading session. Crude is especially sensitive to breaking political and economic news, as well as to weekly storage and production reports.

Trading oil futures entails a substantial amount of risk. If you are an inexperienced or young investor, this probably isn’t for you – it would make more sense for you to take a look at these investments for young adults instead. When trading oil futures, an investor may need to meet a margin call if a position goes against him, or the position may be liquidated at a loss. However, there are some strategies that can define the amount of capital at risk. Investors who want to invest in crude oil futures should understand how they work and the risks involved.

Crude Oil Contract Specifications

A futures contract is an agreement to buy or sell a specific commodity or another financial instrument at a predetermined price in the future. Futures contracts are standardized, which allows them to be traded on an exchange. Some futures contracts are settled by delivery of the physical asset, and others are settled by cash according to the final price of the contract.

A crude oil futures contract represents 1,000 barrels of oil deliverable at some point in the future, depending on the contract month. A $1 move in the price of the oil contract equals $1,000. Assume an investor is long one contract of crude oil at $50. If the price of oil goes to $48, the investor will be behind $2,000 on the position.

The contracts are traded on the New York Mercantile Exchange (NYMEX) exchange. There are futures contracts on both light sweet crude oil and Brent crude oil. Both contracts are settled by physical delivery of the oil. Most investors do not want to be responsible for the physical delivery of this much crude oil. Investors must therefore pay attention to contract delivery and expiration dates. An investor should roll the position to another month or otherwise close out the position before expiration.

Margins for Trading Oil Futures

Futures contracts entail the use of margin for trading. The investor must place a percentage of the contract’s value into his account to open a position; this is known as the initial margin. The margin serves as a financial guarantee that the buyer or seller of the contract will meet obligations under the contract’s terms. The initial margin on a light sweet oil contract is around $4,500 as of October 2015. This represents about 10% of the value of an oil futures contract. The initial margins are subject to modification by the exchange depending on the price and volatility of the underlying commodity.

The investor must keep enough money in the account to maintain the position. This is known as the maintenance margin amount, which is generally a little lower than the initial margin amount. If the value of the account dips below the maintenance margin amount, the investor will receive a margin call. An investor must place more money in the account to meet the margin call and maintain the position or otherwise close the position out at a loss, which is a risk of trading futures.

Oil Spread Trading

One option for investors may be to trade calendar spreads in oil. A calendar spread is buying and selling two contracts for oil with deliveries in different months. For example, an investor may buy an oil contract for December and sell it for next June at the same time. The investor is seeking to profit from the price of oil in December going up versus the price of oil in June. If the contract months are further away, there is a greater potential volatility of the spread. Calendar spreads may require less margin than just buying or selling a single oil futures contract. For example, the initial margin required to buy a December 2015 oil contract and sell a May 2016 oil contract is $850 as of October 2015. This is a much lower margin requirement than buying or selling an oil futures contract outright. There is a great deal of liquidity in oil spreads, so they are easy to trade. These spreads are traded by oil producers, speculators and commodity funds rolling their positions.

The reason for the lower margin requirement is that there is hypothetically less volatility in the movement of the price differential between the two contracts. If there is an unexpected political or economic event that impacts the price of oil, there is a high degree of likelihood that the prices of the oil contracts will rise and fall together to some extent. However, there is still a substantial amount of risk in trading oil calendar spreads; prices between contract months have the potential to make large moves. An investor can still lose a lot of money by trading oil spreads and may be required to meet margin calls if a position goes against him.

Option Spreads

There is also a very active market for options on oil futures contracts. An investor may be able to manage his risk by buying or selling covered vertical option spreads on oil. For example, an investor may believe that the price of oil will rise from $50 to $55 on the December oil futures contract. The investor could buy the $50 call option while simultaneously selling the $55 call option for a net premium of $750. This is known as a debit spread, since the investor is paying the premium to hold the spread.

The maximum amount of money the investor can make on the position is $5,000 less the $750 in premium paid for the spread, less the commissions and other costs. The investor cannot lose any more than the $750 in premium paid plus the commissions and costs. This spread allows the investor to define the amount of capital that he is risking on the trade.

An investor who is bearish on the price of oil could flip the trade over. The investor could sell the $50 call option and buy the $55 call option for a net credit of $750, less commissions and costs. This is known as a credit spread, since the investor receives the $750 as a credit in his account. If the price of oil is below $50 upon the option expiration date, the investor gets to keep the entire amount of the sold premium. The investor cannot make any more money than this amount. However, if the price of oil is above $55 upon expiration, the investor will lose $5,000 less the $750 received for the premium, plus the commissions and costs. This is the maximum the investor can lose, which is still a substantial amount. The advantage of this type of option strategy is that it benefits from time decay, which is the loss in option value moving towards the expiration date.

Read more: Investing in Crude Oil Futures: The Risks and Rewards

— Investopedia

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