The crash in oil prices has created an interesting dilemma for energy stock holders. As regular readers know, I am very big on holding energy stocks for the long-term. I consider some stocks to be “forever holds” in that fossil fuels are so intrinsic to the everyday lives of the human population, you would be crazy not to have long-term exposure to the sector.
But what happens when oil prices — the very thing that supports the energy sector — crash? This is exactly a case in which options can come into play, and one reason they were designed. They permit you to hedge, or offset, some of the losses you might be experiencing if you’re exposed to energy stocks.
Here are some puts and calls you can consider during this period. It’s impossible to say how low oil will go, but I personally plan on seeing oil at $50 (though I don’t expect it will remain there for the long-term, either).
The United States Oil Fund LP (ETF) (USO) basically acts as a tradable proxy for the price of West Texas Intermediate light, sweet crude oil, although it can also invest in other types of energy. In that regard, it is a mildly diversified energy play.
Put Options on USO
The simplest solution would be to buy puts on USO. The amount you buy depends on how much you want to try and hedge your energy holdings.
First, notice that USO options have expiration dates a week apart. That’s good, because it means you are forking over less time-premium. You can just roll in and out of put contracts by the week.
With USO trading at $25.58 at Friday’s close, the Dec. 5 $25.50 puts were selling for 50 cents. So far, we’ve seen USO fall from $35.52 to $25.58, or about $10. During that same period, Exxon Mobil Corporation (XOM) has fallen from $94.43 to $90.54, or about $4.
On a dollar basis, the ratio of USO decline to XOM is about $2.5 to $1. Let’s say you own 100 shares of XOM. You could buy a single USO put, and if XOM falls by $1, we would expect USO to fall by $2.50. So you’d actually profit by $100 once you back out the price of the puts (assuming, of course, that this correlation remains the same). And if you wanted to, you could buy enough puts on USO to hedge against your entire energy portfolio.
Selling Calls on USO and XOM
Another way to go is to sell calls against your energy holdings. Since energy prices are likely to go lower before they go higher, then we might expect the same for energy stocks.
Let’s use USO and XOM again. For USO, you could sell the monthly Dec $25.50 call for 90 cents, so you’d generate $90 per contract. If the price is below $25.50 on Dec. 20, you keep all the money. If the stock is above that price, you’ll have to hand over 100 shares of USO on the expiration date. And if you sold the calls “naked” (you don’t own the underlying stock), then you better have a buy-stop order in place, because you would have to buy them at wherever USO trades that day.
And if you own XOM, you could sell the Dec. 12 $90 call for $2.08. You’ll keep $208 if the stock is below $90 on that date (but if it’s above, your stock will get called away).
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at pdlcapital66@gmail.com and follow his tweets at @ichabodscranium.
