This Bet On Oil Using USO Looks Dicey

This is a weekly column focusing on ETF options by Scott Nations, a proprietary trader and financial engineer with about 20 years of experience in options.

Crude oil has gotten crushed over the past year. While many other ETFs have moved sideways, the United States Oil ETF (USO | B-100), has fallen more than 60 percent, as you can see:

USO seeks to track the price of crude oil futures and does so by owning the front-month (the next delivery month to expire) crude oil futures contracts. It then rolls those positions to the next delivery month as the front-month futures contract nears expiration.

USO uses futures exclusively in its structure, and is different than the vast majority of ETFs that use the open-end or unit investment trust structure. The ETF is structured as a partnership, and as such, does tax reporting to shareholders via a K-1. This complicates tax filing for some investors.

But USO is the best way to get exposure to crude oil futures prices without a futures account. Unfortunately, this best way isn’t a very good way, because the constant rolling of futures from the front month to the second month generates substantial costs for the fund, some hidden in phenomenon like the bid/ask spread for the futures contracts.

USO A Short-Term Tool
Because of these costs, USO is best used as a short-term trading vehicle. One institutional options trader is taking that one step further and using USO options as a very-short-term trading vehicle to get bearish exposure to crude oil prices while defining his risk. He believes USO will be below $12.85 at the close on Friday, Aug. 28.

Our trader got this bearish exposure by buying 17,500 shares of the USO $13 strike put options expiring at the close on Aug. 28. He paid $0.15 per share, and since each option corresponds to 100 shares of USO, he paid a total of $262,500 for the right to sell 1.75 million shares of USO at the $13.00 strike price.

As with any option-buying strategy, the maximum loss is the premium paid, $0.15 per share in this case. His breakeven point is $12.85; at that point, at expiration, the options will be worth the $0.15 paid. But as USO continues to drop below $12.85, the profit continues to increase, as you can see:

The Pitfalls
It’s easy to think this is the sort of trade you might want to make. After all, you’re only risking $15 per options contract, and this trade could make many times that amount if crude oil continues to collapse.

There are three problems with that thinking. First, you only have seven business days for USO to fall about 16 percent, and that’s pretty unlikely. Second, while these options are “dollar cheap,” since they only cost $0.15, from an options trader’s point of view, they’re pretty expensive, since our trader paid a price that assumes USO will be extremely volatile between now and options expiration.

Finally, a little options math tells us that the odds of a drop below $13.00 are only about 25 percent.

Some traders point to a big options trade, like this one, and ask if it makes sense to join in. They think someone trading that big must be smart or have some sort of insight. Not necessarily.

This trader might already be under water on a long position in USO and is limiting further downside. Or she might have a big profit on a short crude oil position and she’s trying to add to that short position while not adding a lot of risk.

Options on ETFs are a great tool, but as with much in life, you have to do your own homework.

At the time of writing, the author held no position in USO or USO options. Follow Scott on Twitter @ScottNations.