Oil reaches a boiling point

Market players should pay close attention to oil prices over the next several weeks as the recent run-up could be forecasting a difficult summer and hurricane season. However, short term traders may see opportunities on the short side assuming that seasonal conditions end up being mild. Last year the financial markets were able to absorb high prices at the gas pump, but this year could be different.



Either way, I see a great opportunity to go neutral over the next few months and take advantage of any large move, regardless of the direction. The two strategies I employ for this call involves buying puts and calls on the oil services fund (OIH) in the form of a straddle or strangle. For a more detailed description on these two strategies, visit the following two links. (Straddle, Strangle). This strategy is for more experienced investors with a higher risk tolerance for losses, however as long as the underlying instrument is volatile with a large trading range, this strategy can produce consistant profitable returns not just with this instrument I am highlighting, but with many other stocks, indexes and exchange traded funds.



For purposes of this post, I will highlight a strangle postion for the near term (1 month) and another postion for longer term (4 months). The criteria for option strangle positions I use to decide which strike prices to buy for both sides (calls & puts) is, if possible, right when the underlying instrument is right in between strike prices and at least one strike price away from where the instrument is at the time of execution. I also try to have an upside or downside bias counter to the recent short term trend and/or when the instrument is trading at a key short term support or resistance level. Finally, I have a preference for the first out of the money strangle or the first in the money strangle. Since this fund is expensive (Over $75 per share) and the postion is for one month, I prefer the first in the money strangle which would contain the in the money 160 calls and the out of the money 165 puts. For a longer term strangle position, I try to buy the out of the money options by one or two strike prices.



The fund is trading near the $165 level (Key short term support level for the past 2 weeks) and the trend has been down the past 4 of days so therefore I am buying the OIH July 160 calls and the OIH July 165 puts for the near term postion. I am also buying the OIH Oct 175 calls and the OIH Oct 155 puts for a longer term postion. My bias is to the upside, so in the first position, the 160 Calls will go up faster than the 165 puts will go down on moves to the upside. If the fund breaks it's support level and goes down significantly, eventually the puts will start to accelerate higher faster than the calls will go down. This price action is determined by what is called the delta, which is the amount the option changes in relation to the move of the underlying instrument. The more in the money the option is, the higher the delta. The highest a delta can get to is a one point representing an equal point for point move of the underlying instrument. For the longer term postion the same holds true only I need a larger move (10-15 points) one way or the other and 4 months gives me plenty of time to realize this move. As the chart below illustrates, the fund moved up almost 40 points, so i feel comfortable with this postion.





The first chart below illustrates the last 3 months trading range and near term support level.



Chart 1



The positions I executed when OIH was trading at $167.03:



One month Strangle

OIH July 160 Calls at $11.00 Needs to rise by at least $5.20 to start making money.

OIH July 165 Puts at $5.20 Needs to fall by at least $11.00 to start making money.





Four month Strangle

OIH Oct 175 Calls at $8.80 Needs to rise by at least $6.20 to start making money.

OIH Oct 155 Puts at $6.20 Needs to fall by at least $8.80 to start making money.



Trading in options involves risk and is not suitable for all investors. Consult with a professional investment advisor to determine your risk tolerance and suitability for this type of position. The writer is a full time trader and investor and owns or participates in many of the strategies he writes about.