Back to the Future: Play Oil with USO ETF Options

Crude oil’s precipitous drop from it’s June highs has yet to show signs of abetting, with U.S. Oil benchmark West Texas Intermediate (WTI) down over 3% again today following Monday’s downside move.

Now trading below $50, oil has moved to a new five and half year low, a move estimated to save the average American over $1400 annually and bolster consumer discretionary spending.

Continued strength in the USD and OPEC’s refusal to cut production would lead me to believe oil has room to move to $45 or even lower.

Saudi Arabia became engaged in a price war in the oil markets in 1985 leading the price of the commodity to collapse. Similar to today, leading up to that point the US had been fighting to break out of Recession and high unemployment. The collapse of oil prices is credited by some as having helped end the recession of the early 1980s.

Some equity options traders I know have been looking to play oil by shorting domestic oil companies, as fracking operations become significantly less viable under $70/barrel, and completely unprofitable below $40/barrel.

I prefer to trade the United States Oil ETF (NYSE: USO, $18.30), as it tracks the underlying commodity relatively well on a percentage basis. USO equity options are also require significantly less capital than the futures.

The USO Feb 18.5 Straddle is trading $2.65, implying a move of this amount in either direction by February expiration ($15.85 to the downside, $21.15 to the upside).

My trade: Buy the USO Feb 17-16 Put Spread for $0.27

Risk: $27 per 1 Lot

Reward: $73 per 1 Lot        Break-even stock price at expiration: $16.73

I like this trade because it gives me plenty of time (45 days to expiration), protecting me from a potential trap or near-term short covering. It also pays nearly 3:1 on my risk capital.