Cash-Secured Probabilities: A Lower Risk Way to Trade Higher Oil Prices

Cash-Secured Probability

The oil market pulled back slightly this morning after another ferocious run in recent days. The latest reports indicate that OPEC – the global oil cartel of 15 nations that coordinate prices and output – won’t reach its quotas in the months ahead. Like any commodity, oil prices react to global supply and demand. 

So, when Western markets lose access to the third-largest exporter in Russia due to the war, supply is lower, demand rises, and prices increase. But – when China announced COVID-19 lockdowns, prices fell. Why? Because the nation is the largest importer of crude. So even if global supply fell, so too did demand (at least for a short while). 

I’ve laid out my thesis that the global market will experience a significant investment gap in the next five years. A $500 billion problem – first laid out by JPMorgan and Moody’s – suggests that crude prices could hit $150 or even $200 in the next few years. 

I know that I can’t time the market. And I know that I can’t predict what oil prices will do – next week, two months from now, or even a year from now. However, I can look at a range of probabilities and use recent price movements to my advantage. Let’s talk about how to make some money in a high probability trade around oil.

Cash-Secured Probabilities

I’ve discussed the merit of selling cash-secured puts in the past. This allows you to pick a specific strike price and a specific date for a stock you want to own. 

Take Occidental Petroleum (OXY). The Buffett-backed oil-and-gas producer in the Permian Basin of Texas trades for about $60 per share. Its CEO recently bought nearly $800,000 in company stock with her own money at roughly $56.24. This executive believes the stock is worth more than that entry-level price. 

So, if I took her lead, I might try to sell the May 20, 2022, $55 put for $1.54 on Tuesday. In this case, I would need $5,500 in margin to sell this cash-secured put. 

It would generate a credit of $154 ($1.54 times the right to 100 shares). If the stock drops under the strike price on or before May 20, and the put buyer assigns the stock to me, I would take control of all 100 shares. 

My “maximum” risk is $5,346. We would deduct the credit from the margin requirement. Naturally, the maximum risk is that the stock’s price would fall to zero. Remember, the odds of this occurring are extremely low. But you can assess your probability of profit on this trade, the total return expected, and your total upside. 

In this case, this trade grants me a 76.3% probability of profit. If the stock remains above $53.46 by May 20, I will profit. If the stock goes higher and the value of the put decreases, I can repurchase it and pocket the net between my sale and my repurchase. 

And if the stock stays above the strike price on the expiration date, I get to keep all $154. Pretty great. But there is a number here that’s rather dull. My maximum return is just 2.88% on my money. I want that number to be higher. So, let’s add another leg to this trade. 

Credit Spread

Instead of just selling the $55 cash-secured put, I can purchase the $50 put as protection and define my risk. Best of all, I require FAR less margin. If I own the $50 put on the same strike date, I no longer have any risk if the stock falls under that price level on or before the expiration date. 

Instead, my maximum risk ties to the margin requirements between the $50 price level and the $55 price level. I’m engaging in a “Credit Spread.” By selling a put at a lower level and then buying one further out of the money, I will receive a credit for the difference between these two prices. 

So, if the May 20, 2022 $55 put trades at $1.54, the May 20, 2022, $50 put trades for $0.72. The credit, in this case, would be $82 to the seller. The maximum risk is $500 minus the credit received – or $418.00. 

But check this out. The potential return here is 19.6% in less than 35 days (or 224% annualized). And the probability of profit remains a hefty 73.8%. So you’re taking on just a bit more risk to profitability while reducing the potential downside of the trade. And again, if the stock falls under $55, you will be assigned the stock. 

If it falls under $50, you have the extra protection to dump shares at that level on or before May 20. Pay close attention to the probability of profit, as it is much higher than trading long calls or cash-secured puts alone.

In this market, it’s tough to time when oil prices might rise higher and higher. Instead of chasing stocks higher with high-priced options, consider improving your profit probability and shooting for annualized gains that are well into triple digits.

Garrett Baldwin
Garrett Baldwin
Garrett Baldwin joined Godesburg Financial Publishing as Chief U.S. Markets Analyst in early 2021. A Johns Hopkins-trained Economist, he’s worked with hedge funds, venture capital firms, angel investors, and economic advisors to the U.S. government. Baldwin specializes in market anomalies and alternative investments. He’s written extensively on momentum, value, insider buying, and other unique strategies that provide investors that elusive edge.
Garrett Baldwin
Garrett Baldwin
Garrett Baldwin joined Godesburg Financial Publishing as Chief U.S. Markets Analyst in early 2021. A Johns Hopkins-trained Economist, he’s worked with hedge funds, venture capital firms, angel investors, and economic advisors to the U.S. government. Baldwin specializes in market anomalies and alternative investments. He’s written extensively on momentum, value, insider buying, and other unique strategies that provide investors that elusive edge.

Related Articles