The price of crude oil has not seen such a precipitous drop in price since 2008 when the overall economy cratered. On July 11th, 2008 crude closed at $144.96. On December 19th, 2008 crude closed at $33.17. Today the economy is not imploding. The drop in price is attributed more to an excess of supply instead of a weakened demand. The spot price of crude is currently trading below $42, less than half of its $96 price twelve months ago. Some analysts are calling for a price below $30 a barrel.
It’s next to impossible to pick tops and bottoms in the market. What if oil is at or near the bottom? Let’s look at an individual equity that closely tracks the price of crude oil. Chevron (CVX) closed at 80.91 on August 19th. On July 24th, 2014 CVX was trading at 134.85. As recently as April 28th, 2015 CVX was trading at 111.73. That’s a 27% drop in less than four months.
You can buy 100 shares of CVX @ 80.91 for $8,091. If you margin your purchase you only have to lay out $4,045.50. Of course should CVX continue to drop, you will need to throw more money into your purchase of CVX. Your maximum possible loss either way is $8,091. Another alternative would be to buy ten CVX January 95 calls @ 0.76. The current bid/ask spread in those options is 0.66-0.76. That would cost you $760. Your upside breakeven point on the trade would be 95.76. Expiration on those options is 150 days away. If the price shot up to 95.76 immediately it would not be a breakeven trade. As you can see on the graph it would be an immensely profitable trade. As time goes by it becomes less and less profitable due to the decline in time value that is embedded in the premium.
Another alternative is the time value spread. It is also known as a time spread, calendar spread or horizontal (time horizon) spread. The CVX October-September 80 call spread is the closest time value spread to being at the money. The bid/ask spread for the CVX October 80 calls is 3.75-3.90 and the bid/ask spread for the CVX September 80 calls is 2.85-2.91. The bid/ask spread for the spread is 0.84-1.05. Intrinsic value for each option is 0.91 and difference in the premiums is comprised entirely of time value. The spread maximizes its profits at the strike price. At this price your long option is at its maximum value when your short option is still worthless. If you are looking for a rebound in CVX this would not be an appropriate strategy.
What would be an appropriate strategy for a rebound is an out of the money call time value spread. The bid/ask spread for the CVX December 95 calls is 0.48-0.53. That means that the market for the CVX January-December 95 call spread is 0.13-0.28. Even if you pay the offer for this spread its maximum possible loss is $280. On a risk adjusted basis this looks like it is the best strategy if the rebound takes place over an extended period of time.