Profit from rising oil prices using options on the XOP

The Oil & Gas Exploration etf (XOP) broke resistance today, advancing 2.6% to a new two year high on heavier than normal volume. Today, North Sea Brent topped $100/barrel signaling a further advance in the price of oil, according to some industry analysts. Also, during periods of rising oil prices, it’s the exploration companies that fare the best.

Should this be the case, one way to play this trend to purchase a long-term (LEAP) call option on the XOP. Currently, the 12 Jan 55 call is trading around $6.35. (The January 2012 call at a $55 strike.)

There are several ways to reduce your cost basis. Writing covered calls would be one method but here you risk getting called away (in which case you’d have to close out your LEAP) which you don’t want to do since your position is that the oil prices will be going up, at least for the next 6-12 months.

A better way to reduce your cost is by writing a bull-put credit spread. Here, you’d sell the higher strike put and buy the lower-priced strike. (You could also just sell the higher-strike put but you’ll then risk getting the stock put to you and you probably don’t want that to happen.) The February 55/50 bull-put credit spread is currently trading for around 50 cents. Should the XOP be trading above $55 at February expiration, you’d pocket the money.

Repeating this process every month (and rolling up to the next appropriate level, depending on where the stock price is) could reduce your cost to essentially nothing come next January when the LEAP expires. By then the LEAP should have appreciated in value leaving you with a tidy profit.

[Note: Please don’t attempt this or any other options strategy without first learning about options and paper-trading them and only risk an amount you can afford to lose.]

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