Monday, December 3, 2007

Strangle OPEC, Make Money.

The fluctuating, inflated price of oil has held the attention of businessmen and lay people alike. Oil's price run-up has certainly been impressive; from a low near $10/barrel in the late 1990's, oil flirted with $100 just last week. This dramatic increase was only rivaled by the price spikes after the oil embargoes and crises in the 1970's and 80's. Just this year, oil is up 30%.

The cause of this increase is debatable. Sure, the incredible growth in China, India, and other emerging economies will strain the production capabilities of the world. But did it really merit such a dramatic increase?

I'll let professional economists and commodities experts argue over the causes and effects of $100 oil. But I think that the average investor can profit off of the volatility in oil.

Oil has retreated from nearly $100 to about $90 per barrel. But where will oil go from here?

Wednesday may be the day that clearly defines a trend. Two defining events will happen this December 5th. First, the weekly oil inventory report will be released, and this week's numbers could be effected by the pipeline explosion late last week. If inventories significantly declined at Cushing, the delivery point for the Nymex contract, that could be a catalysts for a pop back to $100.

The more significant event will be OPEC's meeting in the United Arab Emirates on the same day, this Wednesday, December 5th. Much of the developed world is looking for OPEC to increase production quotas to ease prices. However, with the recent 10% decline in the price of oil (the steepest and quickest in years), OPEC may not be motivated to hike their output. Unless a major event occurs tomorrow, I see oil staying stationary into the two announcements yesterday.

So two possibilities exist:

  • On one extreme, US inventory was steady (or even increased) and OPEC decides to increase production. If those happened together, the price of oil may plummet.
  • However, if inventories are pinched and OPEC deems current production sufficient, then the price of oil could be back near record territory, considering the market is already pricing in a production increase.
I don't know what's going to happen, so I chose to be insulated either way.

I set up a "Strangle" options scheme, using my favorite oil stock, ConocoPhillips. When the stock was trading around $80 today, I bought $75 puts and $85 calls. The calls were about half as expensive as the puts, so I bought twice as much. (Also, I have a tendency to expect upward price movement simply because the oil stocks have declined considerably recently.)

The puts were $63/contract, and the double-strength calls were $78 for two. The at-the-money calls and puts both trade for around $2/contract. So, as long as Conoco moves $5 either way, the transaction will be profitable. (If it moves to the upside, which I made a slight bet on, It'll be a little more lucrative).

Using a "Straddle" (at-the-money calls and puts with the same strike price) or a "Strangle" (out-of-the-money calls and puts at opposing strike prices) can allow a trader to profit off of the volatility of a stock, no matter which way it may move.

Since my crystal ball is out of order, I don't know if oil is going to be up, down, or flat on and after this Wednesday. But as long as something happens and oil moves in one direction, this trade should profit from an unpredictable market.

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