Asanth Sebastian (ASX): profiting from movements in the oil price.

Oil has long been the most traded commodity on a global scale and given its volatility and intra day movements, traders have used derivative contracts such as futures and options to gain exposure to and profit from movements in the oil price.  

Up until recently trading oil as an Australian trader has always been through futures contracts listed on international markets or through over the counter CFDs. There is now a way to gain direct leveraged exposure to movements in the oil price through the ASX: Commodity MINIs.

Commodity MINIs are a type of trading warrant that are listed, traded and settled on ASX. They provide leveraged exposure to the commodity whilst tracking the value of that commodity on a 1 for 1 basis. Other features of Commodity MINIs are that they have no expiry dates and include an embedded stop loss feature ensuring that the trader cannot lose more than there initial outlay. For traders that are unfamiliar with MINIs they can basically be described as a CFD style warrant.

The Commodity MINI over oil provides investors with exposure to the NYMEX (New York Mercantile Exchange) light sweet crude oil futures contract. This contract is used as an international pricing benchmark and is the most liquid oil futures contract.

Commodity MINIs always trade on a 1 for 1 basis with the underlying instrument and therefore the pricing of the MINIs is a relatively simple process. Figure 1 illustrates the oil price since June 2009. As can be seen there have been many uptrends and downtrends in the oil price over this period.

Figure 1: Oil Price (Nymex) $US per barrel since June 2009

The green arrow in the chart above details when you would use a MINI long and the red arrow shows when you would use a MINI short given a decline in the price. We can price a commodity MINI as follows:

The pricing components of a Commodity MINI:

Value of a Commodity MINI Long =

[(Level of the Commodity Futures – Strike Price) / Exchange Rate] / Multiplier

Value of a Commodity MINI Short =

[(Strike Price – Level of the Commodity Futures) / Exchange Rate] / Multiplier

Assume the Oil futures contract was trading at $75 and the MINI long and MINI short had strike prices of $50 and $100 respectively, the multiplier is 10 and the AUD/USD exchange rate is $0.90, the value of the MINI contracts would be as follows:

The initial cost of the MINIs would be:

Mini Long value: [($75 – 50)/ $0.90]/ 10 = $2.78

MINI short value: [($100 – 75)/ $0.90]/ 10 = $2.78

It is also important to note that MINIs have an inbuilt stop loss feature, this stop loss level is set approximately 10% above the strike for MINI longs and 10% below the strike for MINI shorts.

So in the case of the MINI long example if the value of the futures contract falls from $75 to $55 you would be stopped out of our position. Therefore you would limit your risk to a maximum of your initial outlay. The same holds true for the MINI short a rise in the value of the oil futures contract from $75 to $90 will cause the position to cease trading on the ASX.

Using technical indicators to form a view on the direction of oil movements

Once we form a view on the direction of the oil price movement we can use either a MINI long or short to profit if the market does move in our favour. However how do we actually determine which way a movement will occur? To successfully determine a small movement or trend in one direction we can use technical indicators. Two common indicators used by oil traders are a momentum indicator and a Relative Strength Index.

The momentum indicator will measure the current oil price with that of several time periods ago. It will calculate the total difference between the two prices. To calculate the momentum we need the rate of change of this difference divided by the price of several periods ago. The resulting number indicates a signal to trade (buy or sell). Whenever the indicator crosses the zero level, this might indicate a bottom or top, and an opportunity to trade.

Another popular tool used by oil traders is the relative strength index. This indicator compares the strength of the upward price closes to the downward price closes. The RSI indicator is especially helpful in identifying overbought or oversold trading opportunities particularly in a volatile commodity such as oil, where overbought and oversold situations are very common.

A simple expression of RSI = Average price change for up days / Average price change for down days. 

The indicator is bounded by the values 0-100 and can be used as an overbought / oversold indicator. The market is said to be overbought when the indicator is above the 70-80 line and oversold when below the 20-30 region.

Figure 2: Technical indicators can be used to form a view on the direction of oil movements

Example - Profiting from intraday oil price movements

Figure 3 shows the for the NYMEX June futures contract that over the last 3 to 4 months the price of oil has been trading in a range between $70 and $83. The Commodity MINIs value will be based off this June futures contract.

Figure 3: NYMEX June futures contract

Assume as in figure 3 the oil price is at the upper ceiling of its $70 -$83 price range and the momentum indicator has crossed the zero level. This would indicate that a price breakout is imminent and as a trader you can use a MINI long to profit from this movement.

For simplicity let assume that the futures contract moves from $83 to $87 and the AUD/USD exchange rate is $0.90, the strike price of our MINI is $50. The initial cost of the MINI long can be calculated as follows:

MINI long cost: [(Level of the Commodity Futures – Strike Price) / Exchange Rate] / Multiplier

= [($83 - $60) / 0.90]/ 10 = $2.56

A movement in the price of the futures contract from $83 to $87 will increase the value of the MINI as follows:

MINI long cost: [(Level of the Commodity Futures – Strike Price) / Exchange Rate] / Multiplier

= [($87 - $60) / 0.90]/ 10

                        = $3.00

So as you can see the profit on our trade is $0.44 on the MINI long position or a return on investment of 17.2%. It is important to note that when using MINIs much like CFDs positions held overnight will incur interest this interest component will be added onto our strike price on a daily basis. Adverse movements in the exchange rate can also magnify or have an impact on our profits and have to be taken into account when trading MINIs over commodities such as oil.

Asanth Sebastian is the Business Development Manager – Warrants and Structured Products - Australian Securities Exchange (ASX).  As a Business Development Manager Asanth works with warrant issuers and customers spanning retail and institutional markets, in relation to the ASX Warrants Market. For more information see: www.asx.com.au/warrants.

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