Trading Oil Futures

The crude oil market is very liquid, exhibits periods of increased volatility, and offers many opportunities for trades. This makes it a prime candidate for the types of trading strategies we use, but until recently, trading crude oil hasn't been all that accessible for retail investors. Today's show takes a look at the differences between West Texas Intermediate crude oil and Brent crude oil and some potential trading opportunities in these products.

Crude Oil Benchmarks

Before we get into the trades, let's first take a deeper look at the specifics of the products discussed in today's show. Crude oil comes from all over the globe, but the price of just about all of the different crude oil that's pulled out of the ground is pegged to either WTI or Brent, they're the primary benchmarks. Both Brent and WTI Crude are considered "light" and "sweet,"meaning they are low density and have a low-sulfur content. With this type of oil, it's easier for refiners to make products such as gasoline and diesel fuel. There's not too much of a difference between the quality of the two, but WTI is slightly lighter and has a lower sulfur content than Brent crude. WTI is also a US based crude with its delivery point being Cushing, Oklahoma, while Brent is a European based crude. Therefore, supply and demand characteristics specific to the United States will have more of an impact on the price of WTI crude than on Brent. At the same time, the majority of the world uses Brent as a benchmark, so it's very important that we're aware of where the price of Brent Crude is trading and its relationship with WTI.

Contract Specs

The contract size for both WTI (/CL) and Brent (/BZ) is 1,000 barrels per contract and this represents a notional value equal to the current price of a barrel, multiplied by 1,000. Both contracts also trade in $0.01 increments, making the tick size $10.00. This means that for every $0.01 change in the price of crude oil, a trader's position will increase or decrease by $10.00 per 1 contract. So if a trader bought a crude oil contract priced at $59.00 and the price increased to $59.01, the trader would make $10.00. If the price increased to $60, the trader would make $1,000. This represents a fairly large contract and to get into the position a trader will need to meet the initial margin requirement. After getting into the position, the maintenance requirement (minimum value a trader needs in the account to stay in the position) is less than the initial margin requirement, but remember, should the account value drop below the amount required to hold the position, the trader will need to add enough capital to the account so that the account value meets the initial margin requirement again, not just the maintenance requirement.

Market Conditions

As we can see, both products have very similar contract specs and as we might assume, both products are highly correlated. Over the last year, the spread between the two has traded between $25 and $0 with it currently right around $4 wide. Brent and WTI have an almost perfect 3-month correlation at 1, they're almost as closely correlated as we will find when looking at a futures pair. The prices of both WIT and Brent have also cratered by over 50% year over year and this provides us with some potential trading opportunities.

Trade Ideas

Assuming oil has found a bottom and has stabilized within a range, let's explore a few trade ideas. One potential way to play the current market conditions is through a basic, 1-to-1 Brent/WTI bull spread. This trade is setup by buying 1 August /BZ contract and selling 1 August /CL contract right around the current price of $4.39. This is a bullish spread because the idea is that crude increases in price from these levels and we see the spread widen out. When setting up a trade like this, it's always important that we're in the correct contract month and that we're aware of when the different contracts expire.

Another trade that Pete explores is very similar to the Brent/WTI bull spread, but it takes the difference in implied volatility between WTI and Brent into account. Implied Volatility in WTI is above Brent and Pete likes the idea of potentially taking advantage of some time decay in this trade by selling the ATM vertical call spread using the WTI options. This trade gives him the delta equivalent of being short the WTI contract, but with the added benefit of the positive theta decay as a result of the call options. The short call spread acts as the short WTI component of the Brent/WTI bull spread. To add the long Brent component, we simply need to just buy the Brent future.

Don't Drive With One Eye Closed

When trading crude oil it's important to pay attention to the price action and market conditions of the Brent crude oil contract. Even if we're only trading WTI, it's crucial to have an understanding of its relationship with the Brent. Many times Brent will lead the overall market and we don't want to be adversely affected or miss a trading opportunity by not having an eye on what's going on with Brent.