We are not oil experts. This is not an article arguing the reasons why oil prices may rise. This is simply an article discussing what we believe to be an outstanding trading opportunity, based purely on risk-reward dynamics. Using long dated options the returns that could be realized from a reversal in oil’s recent trend are too good to pass on in our view. With a minimal capital allocation and optimizing options to strictly limit our downside on an ongoing basis, we are speculating on a rebound in the oil price. The most likely scenario is that we are incorrect and this trade loses money, but that does not mean that it is not a good trade. In fact, it is one of most compelling trades we have ever entered.

Oil Is Volatile

Stating the obvious, of course oil is volatile. However, often “volatility” is used with a direction bias. For example, commentators talk of volatile days in the stock market, largely when stocks are falling. Volatility in equities is associated with falling prices, reflecting the skew that falls in prices tend to be faster, sharper, and less expected than rallies in stock prices. This is also reflected in the pricing of options on equities, with puts being more expensive than the equivalent calls. This phenomenon is appropriately named “skew”. This is symptomatic of the risk of large drops in stocks prices relative to large gains in prices, but also of the increased demand for downside protection by stock holders, as opposed to demand for call options.

In gold options skew can vary dependant on underlying macro conditions. For in recent years as we moved towards the first Fed hike, puts were more expensive than calls, as the risk of a large fall in the gold price increased with the unwinding of the mass monetary easing by the Federal Reserve. This has now changed with the Fed on hold and the global economic outlook less stable.

Similarly, oil options can have skew.

Massive Gains In Oil Prices Are Far From Impossible

Over the last 20 years, the average change per year in the price of oil has been just under 23%. Out of the last 20 years, 8 of them have seen a move of greater than 30%. Of course past history is not necessarily a guide for future results, but the point we are trying to stress is large moves in oil are commonplace.

Looking at a two year time frame the statistics are more compelling. The average two year gain in oil prices is 44%, with six examples of gains more than 50%. It is the two year time frame that we are targeting with our oil trade.

Options Buy Time, And Cheaply

The reason we utilize options for the majority of our trades is that they allow one to tailor a trade to meet ones view far more precisely than futures, stocks or ETFs. Our view is there is a significant risk of a sizeable rebound in oil prices in coming years and the market is overly bearish on the energy outlook. Our view is not “oil prices will go up”, and therefore we are not buying oil futures, energy companies, or oil ETFs.

What we are buying is time; time for our view to be realized without us being forced to exit the position. If in a few months we are still looking at $30 oil we will not be concerned, we have paid for a long term trade and believe we have got it at an exceptionally cheap price.

Oil Bulls Would Be Foolish To Just Buy Oil

Let us consider someone who is in fact bullish on oil, and firmly believes prices will rise. Such an investor may be purchasing energy stocks and oil futures, but should in our view be using long dated options to form at least part if not all of their strategy. If oil is still at $30 in three months then those energy companies will be struggling to remain liquid and suffering from cash flow issues, in fact we have already seen that in the oil industry. These losses will hit the investor’s portfolio hard, particularly as more capital would have been allocated to the trades. Whereas with our current trade, even if oil is at $1 in two years our portfolio would have lost less than 2.5% p.a.

Oil Bears Should Take Note Of Cheap Protection

Juxtaposed to an oil bull, consider an oil bear currently positioned for further declines. Given the risk-reward dynamics at play, such an investor should consider these long dated options as a hedge, an insurance policy, some cheap protection against their view of lower oil prices being drastically wrong. If the investor is correct and oil continues to plummet, the minor 2.5% annual loss on their portfolio will be easily recovered with the profit from their short oil positions.

Traders Cannot Ignore Risk Reward Dynamics

This trade could return a 500% profit with a bounce in oil back to high the $50s, or 1500% if we get to $70 in two years. We are not massive oil bulls, we are just a trading operation who holds risk management and risk-reward dynamics as the main pillars of our trading methodology. We are not trying to sway oil bears, not wave the oil bull flag, we simply wish to highlight the merits of what we believe is an outstanding trading opportunity, in the purest of forms.