West Texas Intermediate (WTI) crude oil has been on quite a wild ride over the past year. On February 16th of this year it hit a low of $26.05 per barrel. On June 8th the price nearly doubled in less than four months to $51.23. Exxon Mobil Corporation (XOM) is the fifth largest oil company in the world. Saudi Aramco, Sinopec, China National Petroleum Corporation and Petro China rank ahead of Exxon. XOM is, however, much easier to trade than the four biggest firms are.
XOM doesn’t have a 100% correlation to WTI crude it definitely trends in the same direction. On August 24th, 2015 XOM traded as low as 66.55 with the New York Mercantile Exchange (NYMEX) futures trading as low as $38 per barrel. On July 15th, 2016 XOM traded as high as 95.55 with the NYMEX futures trading close to $47 per barrel.
XOM closed at 87.04 on August 2nd. The NYMEX WTI crude closed at 39.82. If you believe that crude will continue to trend downwards you have several alternatives available to you. If you short 500 shares of XOM at 87.04 you will need to come up with $65,280.00. With short stock you need to come up with 150% of the price of the stock as margin. If XOM was to improbably drop all of the way to zero you would net $3,520. The upside risk is unlimited.
Is there a better way to profit from a downward move in XOM? There certainly is a safer and less capital intensive way. You can buy 10 XOM September 87.50 puts for 2.76. You need to come up with $2,760.00. You are tying up less than 5% of your capital when you buy the puts versus shorting the stock. The downside breakeven point (DBEP) for the puts is 84.74. The maximum possible profit for the long puts is $84,740.00. That happens when XOM travel all of the way to zero. The maximum possible loss is $2,760.00. When you are long options you cannot lose any more money than your original investment. The toughest part of the long put position is the fact that long options are a wasting asset. There are 46 days until expiration. Every day the erosion in the premium paid for the options increases exponentially.
A common way to deal with that problem is to short options against your long options position. You can short 10 XOM September 82.50 puts at 1.00. That cuts your long premium exposure down to 1.76. Your maximum possible loss is now $1,760.00. That’s 36% drop in your maximum loss. This is referred to as a bear put spread or a long vertical put spread. While you have lowered your risk you have also lowered your possible reward. When you sell the 82.50 puts you are obligated to take ownership in XOM should XOM trade below 82.50 at expiration. Your maximum possible profit is now $3,240.00. Below 82.50 you get short at 87.50 and long at 82.50 which means the max value for the spread is 5.00.