Remember when the price of one barrel of oil was over $147 USD? The day was July 11th of 2008, and as a technical analyst I remember looking at every momentum indicator on the planet thinking to myself, when this falls it will fall hard.
Six months and four days later, the price of oil tumbled 75% and closed the trading session at $35.40 USD on January 15th, 2009. The economy was in ruins, as the 2009 financial crisis was wreaking havoc. This type of action was enough to make the hairs stand on the necks of the most risk tolerant investors!
This type of action also made us traders flush with excitement and eagerness to take advantage of the opportunity blaring from our screen. Since that point on, the price of oil almost tripled in the next 27 months, only to then lose another 73% from June of 2014 to January of 2016. What a ride!
If there is one thing that oil provides traders, it is the opportunity to catch some really big moves. In 2016, we are on the verge of one of these opportunistic trades, as everyone fights to find the bottom. Is this the bottom? Probably not.
But my point in this article is to help you understand what tools are available to the everyday retail trade and investor to ride the wild roller coaster. Hey Six Flags, new ride called "oil the way down"? (Legal disclaimer: I want 10% of ride revenues if this name is adopted).
When trading oil you have two primary vehicles to use to carry out your trade plans:
Let's compare the two and get into some of the nitty-gritty so you can decide what is the best for you.
Futures are named after their primary function - giving market participants the opportunity to speculate on the future price of the underlying asset. Yes there are companies that use these contracts to hedge their fuel costs (offset), but the vast majority of futures are traded for speculation. So let's just ignore hedging, believe me it is not that sexy (to a trader anyways).
Crude oil futures track the price of "light sweet crude", the international benchmark for "oil prices" (there is also Brent, but let's ignore him, he's less frequented by traders). These light sweet crude contracts are very liquid, and come with tiny spreads that allow retail investors to get access to oil trading at a minimal cost.
The futures contract is denoted by the symbol "CL". Each futures contract gives you direct exposure to the equivalent of 1,000 barrels of oil. At the current $30'ish level, that is $30,000 exposure! So, each futures contract on CL you own will make, or lose you $1,000 for every $1 that oil moves! You might be thinking, wow, a $10 move would make me $10,000, which is a 33% return! Yes, that is true, but it's more...way more.
Futures trading has the benefit of a great deal of leverage (which can help or kill you, so NEVER trade real money to start, always "try it out" on a practice account first - use NinjaTrader and get access to a free trial). Let me show you an example.
I trade with Interactive Brokers, and they allow you to own 1,000 barrels of oil for the day with just an initial balance of $2,500 USD, and require a balance of $2,000 USD to hold this position open.
Let's assume the following example:
This is why oil futures are weapons of trading account destruction when put in the wrong hands. On the upside, you can make vast returns with a small initial capital.
Here are some pro's of trading oil futures:
And now, some of the con's of trading oil futures:
If you wish to trade oil futures, here is some of my advice, from someone who trades CL futures quite frequently:
Here are a few links for more information to get you started:
CL Futures Contract Specs:
Interactive Brokers Futures Margin:
Hit "CTR-F" and type "Crude Oil" to find the futures.
Okay, admit it, reading through the futures section got you extremely excited, then left you feeling worried, maybe even violated. It is not for everyone. In fact, it is almost not for anyone.
The good news is that there are safer ways to start trading oil. Meet the ETF, short for Exchange Traded Fund.
These investment vehicles are designed to replicate the price performance of a certain asset, while maintaining the traditional characteristics of stocks. They trade from 9:30am to 4pm just like stocks, they trade at a share price like stocks, you can chart them and apply technical analysis, see their volume, and you can do to them just about anything you can to individual stocks. This has led to the explosion of their popularity, and they have taken a massive bite out of the mutual fund industry.
When it comes to oil ETFs, you have to make one main decision, do you want to gain exposure to:
If you like to look for value and like holding a share of the business for the long term, here are a few ETFs to get you started:
These ETFs are a good start, but if you are an investor you need to do a ton more research to find the one(s) that align within your investment philosophy. I myself dislike owning individual companies.
I hate the prospect of business risks, fraudulent accounting, rumors, bad cash management, bad people management, etc. How the heck am I supposed to know any of these things to any degree of truthfulness? The annual report? No thanks.
This is why I am a trader of paper assets and owner of real assets. But that is just me, I have been told I can be "different". To each their own.
Now on to the more exciting choice, the ETFs that aim to mimic the price of oil and care about nothing else: (PS - they "mimic" the price of oil by buying oil futures, the thing above, but reduce the risk)
How does trading USO (or any of the above ETFs) actually work?
Here is the sample example as the futures one above:
Here are some of the cons of ETF trading for oil:
Here is a weekly chart comparing each one of the above ETFs to the price of oil since 2006:
At the end of the day, the most pure way to take advantage of oil price movement is by trading the futures. However, the high leverage nature of the product makes it emotionally taxing to trade with a smaller account size.
If your money management strategy will not permit you to lose more than 2% on any given trade (and it should not), you need a $50,000 US account balance to be able to place a $1 stop loss.
Guess what? One buck happens quickly in futures.
If you want to try your hand at futures trading, you can open a demo account with NinjaTrader and trade within a risk free environment with simulated money. The good news is that if you manage to tame the beast in the long run, it can lead you to filthy riches of all sorts.
But remember, for every one of those traders there are 99 that got a one way ticket to the poor house with futures trading.
If you prefer to partake in a slower paced product, ETFs are your best bet, even though they come with the disadvantages of uncorrelated price movement and additional fees.
Either way, the most important realization in trading is that it is not the vessel or the machine that is responsible for success, it is always and solely the operator!
Good luck and good trading.
ABOUT THE AUTHOR
This Drink Forex guest blog post was brought to you by George Papazov.
George Papazov was inspired by his father and started currency trading as a teenager in 2001. After crafting his own strategy he went on to beat the Barclay’s currency index for 5 consecutive years. From there he started to focus on trading stocks, options and eventually futures. The one question he is asked most often and loves to answer is how people can start trading. George enjoyed helping others achieve financial freedom so much that he decided to launch his business in 2012. To this day TRADEPRO Academy is focused on providing a complete development package for individuals serious about trading. George is a passionate coach, educator and most importantly successful practitioner and eternal student of the markets. In his spare time George plays hockey, goes to the gym, travels and spends time with his beautiful fiancée, enjoying life to the fullest.
CONTACT THE AUTHOR
Drink Forex does not offer trading advice and nothing in this article should be considered trading advice. It is for educational purposes only. Additionally, Drink Forex has not taken TradePro Academy's education course.