American crude oil option position
After exercise of respective crude oil options
Long call option
Long put option
Short call option
Short put option
Example with American Calls
Assume, for example, that on September 27, 2021, a trader called Helen purchased American-style call options on April 2022 crude oil futures. The strike price of the options is $90 per barrel. The April 2022 futures price is $96 per barrel on November 1, 2021; Helen wants to exercise her call options. She opens a long April 2022 futures position at the locked-in price of $90 by executing the options. She may either wait until expiry and accept delivery of the actual crude oil underlying the futures contract, or she can terminate the futures trade right once to lock in a $6 ($96 – $90) per barrel profit. Given that the contract size on one crude oil option is 1,000 barrels, $6 per barrel multiplied by 1000 is a $6,000 payment from the position.
Example with European Calls
Oil options in the European model are paid in cash. It should be noted that, unlike American-style options, European-style options may only be exercised on the expiry date. When an in-the-money call option expires, its value is the difference between the actual crude oil futures settlement price and the option strike price multiplied by 1,000 barrels. An in-the-money put option, on the other hand, will be worth the difference between the option strike price and the underlying futures settlement price multiplied by 1,000 when it expires.
Assume, for example, that on September 27,2021, trader Helen purchases European-style call options on April 2022 crude oil futures at a strike price of $95 per barrel at a cost of $3.10 per barrel. The contract units for crude oil futures are 1,000 barrels of crude oil. Helen desires to execute the options on November 1, 2021, when the April 2022 crude oil futures price reaches $100 per barrel. When she does this, she obtains ($100 – $95)*1000 = $5,000 as the option payment. To compute the position’s net profit, deduct the cost of options (the option premium paid to the seller) of $3,100 ($3.1*1000). As a result, the option position’s net profit is $1,900 ($5,000 – $3,100).
Oil Options Vs.Oil Futures
Purchasers of options contracts have the right, but not the responsibility, to buy (call option) or sell (put option) the underlying asset at a predetermined strike price. The maximum a crude oil option holder may lose is the cost of the option, not the underlying futures contract. Futures contracts need more money for a given amount of exposure than options and lack the asymmetric return features of options.
Oil options, unlike some (but not all) crude oil futures contracts, do not need physical delivery at expiry. European-style oil options are cash settled, meaning that holders of in-the-money options get cash rewards upon expiry. In contrast, NYMEX crude oil futures demand delivery at expiry. A trader who is short one futures contract must deliver 1,000 barrels of crude oil at the stated delivery point, but those who are long must accept delivery.
Option positions give extra leverage when the initial margin requirement of futures is more than the premium needed for a similar exposure. Assume the NYMEX needs a $2,400 initial margin on one crude oil futures contract with 1,000 barrels of crude oil as the underlying asset. A futures contract option on that contract may cost $1.20 per barrel. A trader evaluating such options might purchase two oil option contracts for $2,400 (2*$1.20*1,000) each, representing 2,000 barrels of crude oil. However, it is important to note that the inherent leverage of options will be reflected in the option price.
Long call/put crude oil options, unlike crude oil futures, are not margin positions; consequently, they do not need any initial or maintenance margin and would not trigger a margin call. This allows the trader with a long option position to wait out price changes. Should their margined holdings lose value, the futures trader may be required to supply extra money. Long option contracts assist in avoiding this.
Traders may profit from selling crude oil options by collecting premiums (and assuming the inherently much higher risk of short option positions).For traders expecting rangebound prices, writing (selling) out-of-the-money crude oil options might give a chance to make a premium. Remember that a short option position both gets the premium and bears the risk. Selling out-of-the-money options, whether calls or puts, may allow the seller to keep the premium if the option expires in the money. Futures contracts do not provide a comparable chance.
The Bottom Line
Traders looking to boost leverage or achieve an asymmetric return profile may choose to trade crude oil options on the New York Mercantile Exchange or another exchange. Oil option holders get a non-linear risk/return profile not available in futures contracts in exchange for an upfront premium. Furthermore, long option traders are not subject to margin calls, which may demand future traders to supply extra margin money for a devalued position. For traders who want cash settlements, European-style options are ideal.