Oil To Go Below $20?!? Why Traders Make These Crazy Bets, and Why You Shouldn't

Image source: U.S. Department of Energy via Wikimedia Commons.

It's one thing to plop a camera in front of an analyst and ask him or her where the price of oil is heading. Pretty much every time that analystwill say something outlandish to get people's attention. It's a whole different ball game, though, when those same analysts and traders start making outlandish bets on the future price of oil through futures trading.This past week we have seen a large uptick in put options on the price of oil going down.

Way down.

Based on recent trading volumes, the number ofput options with strike prices below $30 per barrel could not be covered even byall the oil stored at the nation's largest oil-trading hub -- Cushing, Okla. Furthermore, some of those bets project oil will go below $20.

To say oil will dip so lowjust because there are put options for that price is a little misleading, though, because the price of oil does not necessarily have to dropthat far for people to make a buck on these options. So let's lookat why some people are willing to make what seems like a long shot bet, and how that should influence your investing strategy.

Put your money where your mouth isTo understand why these bets on oil below $20 aren't what they seem, we need to know what a put option is. A put option is the right, but not the obligation, to sell a commodity for a set price in the future. Basically, a $20 put option on the price of crude says thatif the price of oil sits below $20 per barrelat the option's expiration date, then the person who owns that put option can buy cheaper oil on the open market and sell it for the price locked in with the put option. If it never reaches that price level, then the option expires and the person only loses the premium (fee) she or he paid to buy the option.

Just about every wild prediction regarding oil prices -- either up or down -- is normally accompanied by some sort of explanation that on the surface makes sense. Perhaps it's because OPEC plans on running everyone else out of the market, or maybe it's because the drop in oil prices will cause a major credit crunch that would lead to waning global demand. There are loads of theories out there, and normally they all sound great because they can be tied to something that is happening today.

But here is where things start to get crazy. With oil at $20 or less, a vast majority of oil production around the world would be unprofitable, meaning that pricing is unsustainable based on the fundamentals of supply and demand. So it is quite unlikely oil will ever become that cheap, or at least that the price would remain that lowfor long.

Put option trading: The hot potato and the craps tableTraders do not make these types of bets fully based on the fundamentals of the market. They make them, in fact, because 1) they know how to play on others' fear, and 2) they probably know their way around a craps table.

Traders have that name because they rarely actually own something, rather they just trade it from one person to another. In this case, the people making these wild put options don't produce oil, nor do they own the assets, such as a refinery to consume that oil. So they can't actually hold that put option until expiration because they don't have any of that physical commodity used to make that option.

Instead, the money on this option is more of a bet on people being afraid that oil could drop that low. Today, the premium for a put option (100-share contract) expiring in June with a strike price of $21 a barrel costs $80, while the premium for a put over the same time frame with a strike price of $41 is $1,670. If oil prices decline over the next several months, though, the premium for those $21 puts could be sold for much more than what they sell for today, which would net a profit without oil ever hitting that price.

These kinds of investments are like a game of hot potato. You don't want to be caught with it in your hand when the put expires and the strike price isn't reached.

To do this in the first place might seem absurd, but it happens in pretty much the same way a craps table works. The basic gist of craps is that you roll dice, and you bet that particular number will happen again before craps -- a seven -- is rolled (to all you craps players out there, I know this is oversimplifying things, just bear with me). There are the simple bets that happen rather frequently but don't pay very much, and there are the long shot bets with big payouts that happen quite rarely. Sometimes, you can play these kinds of bets against themselves to increase your odds of winning.

Taking a put option position so far "out of the money" -- the strike price is a long ways away from the current price -- is like making one of those long shot bets on a craps table. It's unlikely to happen, but if oil were to miraculously drop below that strike price, that put option will look pretty valuable. And somebody producing oil without a set price at which to sell that product might be willing to pay a decent price to own that option. So taking a small position in an out of the money put like this might never pan out, but if it does the payout could be huge.

What a Fool believesMaybe today, maybe tomorrow, chances are there will be news stories with headlines like, "Oil Analyst: Brent to go to.." or "Experts Betting oil at $0...". We see them every day, and you might be tempted to do something similar with your money since their logic seems sound and they are making an "investment" on that prediction though these put options. A word of advice: you're better off sitting put rather than taking a put option position.

If any of that strategy about put options on commodity prices sounded a little like gambling to you, that's because for the most part it is. I'm guessing you don't have thousands of barrels of oil to sell, so making bets with options or futures contracts on commodities is just pure speculation based on your projection of the future price of oil. If there is anything to be learned from commodities trading, just like at the casino, it's thateventually,the house always wins.

The article Oil To Go Below $20?!? Why Traders Make These Crazy Bets, and Why You Shouldn't originally appeared on Fool.com.

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