Options Are a Good Way to Play Oil

Wait a minute...wasn't that the same question I was asking just a few months ago, in my column of July 3? It is, and even though I sold some calls on a few energy positions to raise some cash, I didn't sell any shares. With oil now regularly topping $80 a barrel, I'm glad I didn't.

Back then, oil had just crossed the $70 threshold. Under my old system of buying lower and selling higher, I bought energy shares when oil was at $50, and sold them at $70. But this system has been in flux due to rapidly changing conditions in the energy markets. In the old days, I used to buy energy shares when gasoline was $1 at the pump, and sell when it hit $2. That system had the virtue of constant visibility and simplicity and worked for years. How quaint it seems now.

Back in July I had the foresight to shift my trading range to $60-$80. In large part, that's because the falling dollar was pushing up oil prices even without any big shifts in the supply/demand equation, since oil is priced in dollars. The Federal Reserve's decision to cut interest rates has dealt the dollar a further blow, not to mention fueling inflation fears. That's a double boost for oil, which as a commodity, is also a good inflation hedge. No wonder oil is hitting new records, in nominal if not inflation-adjusted returns.

So is it time to shift my trading range upwards again, to the $70-$90 range? I don't think so. While consistency may be the hobgoblin of small minds, there's no point to having a trading discipline if you throw it out every time you hit a threshold. So I plan to again raise some cash on my energy positions. A good way to do that without actually selling them is to sell some out-of-the-money calls, as I did last summer.

So far that has been a profitable exercise. Although oil prices are up 14% since July 3, oil stocks haven't kept pace. Gasoline refiners, especially, have been lagging. So the Valero (VLO) calls I sold expired worthless in September, meaning I kept the shares and the cash I received when I sold them. The jury is still out on the Suncor Energy (SU) calls I sold with a strike price of 100, which don't expire until December. Suncor seemed well on its way to reaching the $100-a-share level (it crossed it intraday on Sept. 18) until the Alberta government stepped in and threatened to levy more taxes on the Canadian oil sands project which is the heart of Suncor's business. It's been trading in the $90s since. But even shares of big integrated producers like Exxon Mobil (XOM), Chevron (CVX) and ConocoPhillips (COP) haven't kept pace with the rise in oil prices.

Thanks to all the recent market volatility, options are fetching bigger premiums than ever, which makes it a good time to sell some calls. When I checked this week, the XOM 100s expiring in April were going for $4; the CVX 100s expiring in March were $3.50; and the COP 95s expiring in May were $5. If the shares are called at those prices on those expiration dates, that represents annualized rates of return of 36%, 40% and 37% respectively from their current trading prices. If the shares don't reach the strike prices, you'll keep the premium and the shares — and be in a position to sell more calls when prices rally again.

I call that a good trade.