Options "Spreaders" Bullish on Oil

Real-time Monetary Inflation (per annum): 7.9%

You can have a lot of fun with a headline using the term "bull spreaders." Here, we're not talking of those verbose punters laying it on thick and heavy about their trading prowess. We're instead referring to those cautiously bullish option investors who wanted to buy as much time for as little money as possible for their oil expectations to be realized.

Our March 5 article, "Oil Spreaders Heed Schork's Call," illustrated a trade recommended by energy maven Stephen Schork. Because Schork set his target for crude - at $60 to $65 per barrel - some 12 to 18 months out, he spurned oil ETFs as the investment of choice. Readers of this column can understand why. A year's worth of contango rolls can eat deeply into returns. The quarterly contango now represents a negative roll yield of 8%. Pay for a couple of those and you begin to lose real money (for background, see "Contango's Cost To OIL ETF Investors").

The way out of this, reasoned Schork, was to use, but not directly enter, the futures market. He suggested buying calls on oil futures a year or more out and financing part of the purchase price through sales of further-out-of-the-money calls. In other words, Schork pitched bull call spreads - a limited risk (and limited return) strategy designed to capitalize upon a modestly volatile market.

March 2010 crude oil was at $53.15 when we noted activity in the $75/$90 call spread:

 

	Strike Price	Premium ($/bbl)
Long	$75	-$3.36
Short	$90	+$1.86
Net		-$1.50

 

Out-of-the-money call spreads were being bought for $1,500 (that's $1.50 per barrel, mind you); less than a fifth the outlay required for crude oil futures. No roll cost either.

March 2010 futures closed at $63.12 on Thursday. The call spread, though still out-of-the-money, is worth twice its opening value:

 

	Strike Price	Premium ($/bbl)
Long	$75	+$5.90
Short	$90	-$2.91
Net		+$2.99

 

More importantly, March oil is now within Schork's target range. Maybe it's time for call spreaders to peel half of these calls off.

 

NYMEX Crude Oil (March 2010)