Buying Gasoline Call Options to Profit from a Rise in Gasoline Prices

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Contents

Buying Gasoline Call Options to Profit from a Rise in Gasoline Prices

If you are bullish on gasoline, you can profit from a rise in gasoline price by buying (going long) gasoline call options.

Example: Long Gasoline Call Option

You observed that the near-month NYMEX Gasoline futures contract is trading at the price of USD 1.1400 per gallon. A NYMEX Gasoline call option with the same expiration month and a nearby strike price of USD 1.1000 is being priced at USD 0.0800/gal. Since each underlying NYMEX Gasoline futures contract represents 42000 gallons of gasoline, the premium you need to pay to own the call option is USD 3,360.

Assuming that by option expiration day, the price of the underlying gasoline futures has risen by 15% and is now trading at USD 1.3110 per gallon. At this price, your call option is now in the money.

Gain from Call Option Exercise

By exercising your call option now, you get to assume a long position in the underlying gasoline futures at the strike price of USD 1.1000. This means that you get to buy the underlying gasoline at only USD 1.1000/gal on delivery day.

To take profit, you enter an offsetting short futures position in one contract of the underlying gasoline futures at the market price of USD 1.3110 per gallon, resulting in a gain of USD 0.2110/gal. Since each NYMEX Gasoline call option covers 42000 gallons of gasoline, gain from the long call position is USD 8,862. Deducting the initial premium of USD 3,360 you paid to buy the call option, your net profit from the long call strategy will come to USD 5,502.

Long Gasoline Call Option Strategy
Gain from Option Exercise = (Market Price of Underlying Futures – Option Strike Price) x Contract Size
= (USD 1.3110/gal – USD 1.1000/gal) x 42000 gal
= USD 8,862
Investment = Initial Premium Paid
= USD 3,360
Net Profit = Gain from Option Exercise – Investment
= USD 8,862 – USD 3,360
= USD 5,502
Return on Investment = 164%

Sell-to-Close Call Option

In practice, there is often no need to exercise the call option to realise the profit. You can close out the position by selling the call option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the gasoline option sale will be equal to it’s intrinsic value.

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Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

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Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Buying (Going Long) Gasoline Futures to Profit from a Rise in Gasoline Prices

If you are bullish on gasoline, you can profit from a rise in gasoline price by taking up a long position in the gasoline futures market. You can do so by buying (going long) one or more gasoline futures contracts at a futures exchange.

Example: Long Gasoline Futures Trade

You decide to go long one near-month TOCOM Gasoline Futures contract at the price of JPY 31,820 per kiloliter. Since each TOCOM Gasoline Futures contract represents 50 kiloliters of gasoline, the value of the futures contract is JPY 1,591,000. However, instead of paying the full value of the contract, you will only be required to deposit an initial margin of JPY 210,000 to open the long futures position.

Assuming that a week later, the price of gasoline rises and correspondingly, the price of gasoline futures jumps to JPY 35,002 per kiloliter. Each contract is now worth JPY 1,750,100. So by selling your futures contract now, you can exit your long position in gasoline futures with a profit of JPY 159,100.

Long Gasoline Futures Strategy: Buy LOW, Sell HIGH
BUY 50 kiloliters of gasoline at JPY 31,820/kl JPY 1,591,000
SELL 50 kiloliters of gasoline at JPY 35,002/kl JPY 1,750,100
Profit JPY 159,100
Investment (Initial Margin) JPY 210,000
Return on Investment 76%

Margin Requirements & Leverage

In the examples shown above, although gasoline prices have moved by only 10%, the ROI generated is 76%. This leverage is made possible by the relatively low margin (approximately 13%) required to control a large amount of gasoline represented by each contract.

Leverage is a double edged weapon. The above examples only depict positive scenarios whereby the market is favorable towards you. If the market turn against you, you will be required to top up your account to meet the margin requirements in order for your futures position to remain open.

Learn More About Gasoline Futures & Options Trading

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Buying Gasoline Call Options to Profit from a Rise in Gasoline Prices

As all large fuel consuming companies are well aware, fuel prices have increased significantly over the past couple months. Relative to their June lows, heating oil, gasoil and gasoline futures have increased all increased by about 20%.

As such we thought it would be beneficial to explain how fuel consumers can optimize their fixed price swaps, which are likely to be in-the-money, by converting them into call options. The idea being that such a conversion will provide you with continued protection against increasing fuel prices, the ability to monetize your current gains and the potential to benefit should fuel prices reverse course and decline in the coming months.

While one could easily accomplish this by selling your fixed price swaps, “pocketing” the gains, and buying call options, there is a more effective strategy which results in the same solution at a lower cost. In the trading world, we call it a synthetic call option. In practice, it is the combination of a fixed price swap and a put option, which when combined, creates a position which is the same as a call option, also called a price cap.

As an example, let’s assume that Crimson Airways (a fictitious airline) has hedged their anticipated October 2020 fuel consumption by purchasing an October NYMEX heating oil calendar swap at a price of $2.60/gallon. Given the recent increase in heating oil prices, Crimson’s swap is currently trading for approximately $3.10/gallon, equating to a position which is currently in-the-money by 50 cents per gallons. If Crimson were to sell the swap, for an approximate gain of $0.50/gallon, they could then purchase an $3.10 October 2020 heating oil Asian (average price) call option for approximately $0.1250/gallon. However, as previously mentioned, this is an “expensive” way to accomplish their goal as they would have to execute two transactions (sell the swap and then purchase the call option), which would subject them to the “bid/ask spread” on both occasions. In layman’s terms, this means that they would have to compensate their counter-party (via the counter-party’s profit margin on each transaction) on both the sale of the swap and the purchase of the call option, which could easily cost them an additional penny per gallon.

As an alternative, which would result in the same result, yet at a lower cost, Crimson could simply purchase $3.10 October 2020 heating oil Asian (average price) put option for approximately $0.1175/gallon. By retaining their existing swap and purchasing the $3.10 put option, Crimson only has to enter into one new transaction, which means that they are only subjected to the bid/ask spread on one transaction. In addition, due to call skew in October $3.10 heating oil options (which essentially means that the market currently considers the call options more dear than the put options), Crimson will save an additional $0.0075/gallon by buying the $3.10 put option rather than the selling the $2.60 swap and purchasing the $3.10 call option.

So how does the synthetic call option provide Crimson with the same result as selling the $2.60 fixed price swap, pocketing the gain and subsequently buying a $3.10 call option? In short, the $2.50 fixed price swap will continue to provides Crimson with a hedge against rising heating oil prices while the $3.10 put call option will provide them with a penny for penny gain should October heating oil prices average less than $3.10/gallon.

To put this example into a numerical context, if heating oil prices decline significantly over the next couple months and the average settlement price for heating oil futures during the month of October is $2.00/gallon, Crimson will gain $1.10/gallon on the $3.10 put option and lose $0.60/gallon on the $2.60 swap for a net gain of $0.3825/gallon (including the put option premium of $0.1175/gallon). On the other hand, if heating oil prices continue to increase and the average settlement price for heating oil futures during the month of October is $4.00/gallon, Crimson will gain $1.40 on the $2.60 fixed price swap and the $3.10 put option will expire worthless (as it is out-of-the-money) for a net gain of $1.2825/gallon (including the put option premium of $0.1175/gallon).

As a result of converting the $2.60 fixed price swap into a synthetic call option, Crimson has positioned itself as follows:

  1. They remain well hedged against heating oil prices rising further
  2. They can monetize the current “gain” of $0.50/gallon on the swap
  3. They eliminate a potential loss on the swap should October heating oil prices average less than $2.60/gallon

In summary, by paying the $0.1175/gallon premium and converting their fixed price swap into a synthetic call option, Crimson has guaranteed itself a “win-win” situation, regardless of whether heating oil prices increase or decrease over the next 72 days.

While many companies approach hedging with a “set it and forget it” mentality, this examples shows that you can potentially increase your bottom line, without incurring any additional risk, by actively managing your hedging program.

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