Oil Market Begs To Be Shorted—Modestly

October 28, 2010


Buying the high-struck contract against the sale of the lower-struck put results in a net debit, or cash outlay, of 32 cents. Since options come in 100-share contracts, that translates to $32 per spread:


Bear Put Spread With USO @ $35.42 (27-Oct-10)




Long 1 $34 Dec put



Short 1 $33 Dec put

+ 0.75






USO May - Oct 2010


Each option's delta coefficient reflects the contract's sensitivity to price movements in the underlying USO fund shares. Buying a put conveys negative delta, meaning the contract's value increases as the fund's price declines, while selling a put bestows positive delta, so the put's value (a liability here) increases along with the fund's price.

Netting everything out, your $32 investment gets you a position that, all things held constant, would appreciate by 12 cents for every dollar decline in the price of USO. As you can see, that's not very bearish.

There's a limit to the position's profit potential, though. If the USO fund's price moves down toward the lower strike price, the bear put spread works like a long outright put. At a certain point, however, an increase in the short put premium—again, a liability that must be bought in to liquidate—puts a lid on the position's profit.

The best scenario for you, the put spreader, is for USO's price to fall below the lower strike price. At expiration, the strategy's profit would then be maxed out. Even if USO falls to zero, the optimal return at expiration is the difference in the two options' strikes, minus the initial debit paid to open the spread. Thus,


Maximum Gain = (High Strike Price - Low Strike Price) - Net Debit, or $0.68


For your $34/$33 spread, that means 68 cents a share, or $68 per spread. Considering your $32 investment, that's a 213 percent return. That's a reward-to-risk ratio of better than 2-to-1, because the spread's losses are limited to the net debit paid:


Maximum Loss = Net Debit, or $0.32


Your worst case at expiration would be seeing USO's share price above your spread's higher strike price. In that case, both options would expire worthless, turning the initial outlay for the position into a loss.

The strategy breaks even if, at expiration, USO's price is below the higher strike by the amount of the initial debit. In that case, the short put would expire worthless, and the long put's intrinsic value would equal the debit:


Breakeven = High Strike Price - Net Debit, or $33.68


As with any other option position, an investor needn't wait for expiration to close out a spread. In fact, it's possible to garner a return higher than the 68-cent expiration profit illustrated above on an early move in USO's price.

If USO, for example, fell to $32 in a month from now—21 days before expiry—a gain of 71 cents could be obtained. And that's assuming constant volatility—returns could be even more dramatic if volatility jumps.

So, there you have it. A modest risk for a not-too-shabby reward if oil—and USO prices—should decline moderately. The put spread's breakeven point is only $1.74, or 4.9 percent, below USO's current price. Considering the market's recent price action, that target seems easy to hit.


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