Trading Crude Oil

By: Kyle McEwan
Date: August 8, 2011

Crude oil futures contracts began trading in 1983 on the New York Mercantile Exchange (NYMEX) in "The Pits". The Pits are where traders with a membership to the exchange meet to buy and sell with one another a commodity or security for a personal account, an institution or on behalf of clients. The Pits in New York still exist today, however, virtually all trading has moved to Globex, the electronic exchange of the CME. Crude Oil futures contracts enable large oil companies to hedge crude oil prices and give speculators an avenue to make bets on the direction of crude oil. Crude oil is an excellent commodity for a speculator to trade regardless of investment time frame due to its volatility, access to leverage and immense liquidity.

The price of crude oil is not determined by an exchange or government, but is auctioned continuously by speculators and hedgers in a process of price discovery. Traders consider supply and demand, future growth prospects for the economy, the price of the American dollar and many other factors to determine a fair price. Since all of these factors are constantly changing, it is not surprising that the price of crude oil is constantly changing as well creating volatility . Volatility creates opportunity for traders to make profit by purchasing crude oil when it is perceived to be undervalued and selling crude oil when it is overpriced. Crude Oil futures can be sold to create a short position just as easily as it can be purchased to create a long position.

Oil has had significant price swings over the past decade moving from a low of $10.35 in 1998 to an all time high of $147.27 in July 2008. Crude rapidly fell from its high during the financial crisis back to a low of $32.48 in December 2008. Oil prices have seen a surge from the bottom due to a combination of global supply shortages, rising geopolitical tensions and rapid demand growth from emerging economies. Long term investors generally buy and hold a commodity such as crude oil, while short term investors will buy or sell crude oil for a few minutes, days or months depending on their short term style. If a long term investor purchased crude oil in 2001 for approximately $17/barrel they would have an unrealized profit of nearly 430% given a crude oil price of $90/barrel today. Although crude oil has been volatile over the past decade, investors that buy and hold have experienced exceptional returns which have been used to hedge inflation and diversify their portfolio. An important point to make is that futures contracts have expiration dates and other implications that affect the investors return. It is recommended that an investor contact our group or a qualified futures advisor before implementing a long term purchase of crude oil.

Short term investors look to trade crude oil and make a profit by taking advantage of perceived mispricing. Below is a daily chart and a 10 minute chart. As a general rule of thumb, the longer time horizon an investor has the more of a price fluctuation the investor can expect. For example, if the swing trader were to buy crude oil at $94.00, hold it for 10 days then sell it at $99.35 they would have made $5350 or 63% return on initial margin of $8438.  Traders can trade these types of moves with unleveraged by putting up the capital for the entire notional value of the contract which will be explained further.  If the trader put up the entire value of the contract ($94,000) they would have still made $5350 but the return on the investment would be 5.69%.  If the day trader were to sell crude oil at $91.60, hold it for 40 minutes then buy it back at $90.75 they would have made $850 or roughly 10% return on initial margin of $8438. It may seem that swing trading is much more lucrative than day trading on a per trade basis, however, the amount of leverage that a trader incorporates into their strategy can drastically affect returns as well as risk levels.

Leverage within the crude oil market is prevalent and has propelled some traders to extraordinary returns. However, leverage is a double edged sword and traders can lose significant amounts of money due to leverage, sometimes even more than the value of their trading account. 

A standard sized crude oil futures contract controls 1000 barrels of oil . At a price of $100 per barrel the notional value of the contract is $100,000 (1000 barrels * $100). Traders are required to deposit with the exchange the initial margin, which currently stands at $8,438.  The margin is set by the exchange and subject to change at anytime. If a trader were very aggressive he/she could control $100,000 of crude oil with an investment of only $8,438 or 8.43% of the notional value. This is a leverage ratio of 11.85. For each $1 move in the price of crude oil there is a $1000 per contract impact on the gain or loss. Below is an example:

Suppose you were to buy a September 2011 crude oil contract for a price of $100 in anticipation of the price of oil appreciating. 

In a week's time the price then moves to $105, you could subsequently sell a futures contract with the same contract expiry month.

Your profit would be $5000 ($5 * 1000 barrels).
If you were to use no leverage your return would be 5% while if you were to use the maximum amount of leverage your return would be nearly 60%.

You could also speculate on the price of oil going down just as easily by selling a September 2011 futures contract at $100.

However, if you sold the contract at $100 and the price appreciated to $105 there would be a loss on the trade.

Your loss would be -$5000 (-$5 * 1000 barrels).
If you were to use no leverage your return would be -5% while if you were to use the maximum amount of leverage your return would be nearly -60%.

The amount of leverage incorporated in a trading strategy is very important and can drastically affect rates of return. Traders must always understand the risks that they are taking on before making a trade.

If you are interested in learning more about trading crude oil please feel free to give us a call at 416-862-3946 or send an email to kyle_mcewan@scotiamcleod.com.

Disclaimer: Opinions expressed are subject to change without notice. This report should not be construed as a request to engage in any transaction involving the purchase and sale of a futures contract and/or commodity options thereon. The risk of loss in trading futures contracts or commodity options can be substantial, and investors should carefully consider the inherent risks of such an investment in light of their financial condition.