Negative Oil Prices: What does it Mean and How to Profit from Record Low Oil Prices?

The price of one American oil futures contract crashed on Monday into the negative for the first time in history.

The May WTI crude contract CL.1, -113.23% CLK20, -113.23% closed at -$37.63 a barrel, a one-day drop of $55.90, or 306%, according to Dow Jones Market Data. Those prices—at negative $$ per barrel—mean that companies must now pay a buyer to take oil off their hands and store it if they want to exit the market. 

Since the COVID-19 epidemic started, S&P500 crashed over 30% to 2192+/- from the high of $3393.52 in just matter of 4weeks. Dow Jones, Dow Transport, Nasdaq and Russell 2000 all suffered similar fates. However, market panic was nowhere else as pronounced as in Crude Oil.

Crude Oil Price War

On 8 March 2020, Saudi Arabia initiated a price war with Russia, facilitating a significant fall in the price of oil. Over a few weeks, US oil prices fell by 34%, crude oil fell by 26%, and Brent oil fell by 24%. The price war was triggered by a breakup in dialogue between the Organization of the Petroleum Exporting Countries (OPEC) and Russia over proposed oil-production cuts in the midst of the 2019–20 coronavirus pandemic. According to many news sources, Russia walked out of the agreement, leading to the fall of the OPEC alliance. Oil prices had already fallen 30% since the start of the year due to a drop in demand.

COVID-19 Pandemic

Since COVID-19 pandemic started to spread outside of china, crude oil experienced major decline in demand and hence prices kept on cratering.

The supply glut and the on-going pricing war added to selling panic. Pretty much the whole world went into demand shock, triggering further fall of crude oil prices.

Here is a chart showing how crude oil prices started to drop significantly as more and more covid-19 deaths were being announced worldwide.

(Sources - The COVID-19 deaths data is from worldometers.info and adjusted crude oil prices from Yahoo finance)

Crude oil prices dropped so much that on Monday, The May WTI crude contract CL.1, -113.23% CLK20, -113.23% closed at -$37.63 a barrel, a one-day drop of $55.90, or 306%, according to Dow Jones Market Data.

Think about it for a minute. Negative $37.63!!!

Oil Implied volatility spiked to record levels, above 500%.

In an advisory notice published late on Tuesday, the CME Group said that, effective April 22, the clearing house will switch its options pricing and valuation model for certain crude and energy products (i.e., oil) to Bachelier "to accommodate negative prices in the underlying futures and allow for listing of options contracts with negative strikes for the set of products specifies below."

The switch will be effective for the margin cycle run at the end of trading on April 22 and will remain in place until further notice.

So if you are wondering, how can you sell $0.5 Put option on Crude Oil Futures for $1.76 credit (I did a real money trade, screenshot below), it is because, there is a fear in the market that Jun futures might also be settled for negative prices!!

So, before you start selling tons of these negative value puts, make sure you have the capital and guts to carry such trades, because the risk is real.

Maximize Profit, Minimize Risk

So, how can you benefit from record low prices? What trades can you place to profit while minimizing your risk?

There are multiple ways you can profit from such a market crash in Oil:

  1. As Implied Volatility has surged to record levels, you can Sell Put Option on Oil Futures or Oil ETFs. However, Oil futures have the risk of settling in negative value like it did a while ago. If that happens, the sold put will actually incur heavy losses. Selling Put Option on plain ETF, such as USO, might be better than selling Put Option on Crude Oil Futures.
  2. One may also choose Bull Put Vertical spread and benefit from heightened volatility. On one hand, a Bull Put spread will limit the risk (and gains), on the other hand, it will still be a high ROI trade.
  3. You may choose to go long on plain oil ETF (or long Call option) such as USO, Oil Services ETF such as OIH, or even choose bluechip energy companies such as Chevron (CVX), Exxon Mobile (XOM), OXY, etc. But you will have to wait for the sector to recover to give you outsize returns.

My preferred way is #2. Here is how you can construct a beautiful trade:

  • Sell To Open $1 Put (22 days to Expiry)
  • Buy to Open $0.5 Put (22 days to Expiry)
  • Collect $0.25 credit
  • Max Risk $0.25 (or $0.25x$1,000 = $250) per contract
  • Max Profit $0.25 (or $0.25x$1,000 = $250) per contract

Here is my real money trade:

Here my maximum loss is U$1,250 if oil closes below $0.5. While, my maximum gain is also US$1,250 assuming oil closes above $0.5 in 22 days.

It doesn't matter even if Oil drops to negative $50, my max risk is still limited to US$1,250 only.

Now, that's smart way of trading options.

Join conversation by asking question or leaving a comment below.

Trade Update:

I closed my Bull Put Spreads the next day and booked US$3050 profits.

Disclaimer: I have many more trades on Crude Oil. This is just one of the trades from my real money portfolio. You should do your due diligence before investing in options. Standard disclaimers apply.

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