Low Risk Investment in Oil and Options

In my last post, I mentioned investing in oil and gas by using exchange traded funds (ETF) and covered call options. As a result of comments and discussions since, I realized my explanation of this strategy was rather cryptic, especially for those with little experience in ETFs or options.

I'll state up front that I'm not an options expert, but this strategy is relatively safe and easy and as a result could well meet the needs of a large number of investors right now. So, let me explain in a bit more depth what was suggested.

My premise was that oil and gas, at prices below $40/barrel and $5/mmbtu respectively, seem to be at a point where the downside is likely to be limited and some potential up side seems like a good bet.

Obviously, one way to play this scenario would be to buy oil and gas. But, actually owning oil and gas is difficult for most investors. A relatively convenient alternative is to own ETFs such as USO and UNG. These funds attempt to track the prices of oil and gas respectively and are easily traded like stocks on the NYSE. So, owning these ETFs are a reasonably good proxy for owning oil and gas directly.

I believe that owning these ETFs is likely to be a good investment over the next few months or years, but it involves both signficant risks as well as significant profit potential. However, with the recent fall of the stock market, my normal investment system, Dollar Cost Averaging on Steroids (see the link to Personal Finance Guru on the right for more details), has essentially all my risk capital tied up in stock index mutual funds and I do not believe it is the time to sell these funds.

A greater need right now is for relatively safe and attractive investments for cash which may be needed over the next 3-5 years. Alternatively for some, it might be a place to hide from the markets, although this doesn't fit with my strategy currently. That is where selling covered call options on the mentioned ETFs comes in.

In effect, they are a way to trade some of the risk as well as some of the higher potential profits for some risk protection and a higher probability of lower but reasonable profits. To do this, you would buy (or own) one of the ETFs, and sell covered call options on the ETF for the future. Because of general expectations that oil and gas will be higher in the near future than they are today, the sell price of the calls is relatively high.

Let me give an example of a trade I recently made to illustrate. I purchased 100 shares of USO for $29.65 per share. I then immediately sold covered $31 call options for July 2009 for $4.40 per share. The result is that if prices remain steady I'll pocket the $4.40 and keep my ETF shares, netting about 15% ($4.40 on the $29.65 investment) for the six month period. If the ETF trades above $31 during the period the options may be exercised and I would be forced to sell the shares for $31 and pocket the $4.40, resulting in a gain of about 19% ($4.40 + $1.35 on the $29.65 investment) in six months or less. If the fund falls, I would still have some lessor profit unless it falls more than 15%, or lower than $25.25 ($29.65 - $4.40). Of course, the ETF could fall lower than $25.25, in which case I would lose, but would lose $4.40 less than if I had just purchased the ETF without selling the option.

Hopefully this example makes clear how this process can help meet objectives for a good return with less risk, a common objective for a lot of cash today. Note though, that it is not entirely risk free, and you have to trade potential higher returns for the reduced risk. This process, of course, can work for virtually any stock or ETF investment. But the high expectations that exist in the market for future energy prices (as confirmed by the oil contango and relatively high option prices), combined with my belief that oil prices are unlikely to drop too much further for any sustained period, make this a relatively attractive investment. And, it is a relatively simple process that is easy and practical for most investors.

If you wanted to get just a bit more sophisticated, it is relatively easy to taylor this strategy to your own shade of bearishness, bullishness or agressiveness. If you are more bearish, you might sell the options for a lower strike price (say $28 for the above example) which would increase your downside protection while giving up some upside potential. If you are more bullish, you could sell the options at a higher strike price (say $35 for the above example), which would decrease the downside protection while increasing the upside potential.

I'd love to hear comments, either on something I've missed or a better alternative. But, for my low risk cash, this strategy seems hard to beat.