One of the problems facing someone wishing to trade futures contracts on oil is the margin required can be very large, requiring a large trading account and also presenting a large risk when trading.
A very simple solution to the problem is to purchase options on the underlying oil contract. The advantages to the trader are, the amounts required to trade are smaller, hence you can trade with a smaller account and the dollar value of the risk is known (and smaller) and defined prior to placing the trade.
Purchasing options for this for this reason is not new. The concept can be applied to any commodity or stock and is known as directional trading. Below we describe the concept with some detail.
An OPTION is the right but not obligation to sell (a PUT option) or buy (a CALL option) one contract of the underlying equity (in this case a contract of crude oil, 1000 barrels) at a certain price (called the strike price) by a certain time (this is called the option expiry date, do not confuse that with the contract expiry date).
You as the option buyer pay a premium to the option seller for this right. How you make your income is if the price of the underlying oil contract moves in your favor, the value of the option moves in your favor, that is it becomes worth more.
For example, if your analysis indicated that the price was going to go up you would purchase a CALL option if you believed the price were going to go down you would purchase a PUT option. This is why it is known as directional trading. The value of the option will only increase if the price of the oil goes up or down, that is, if the price of the oil contract does not move up or down then your bought option will not gain in value and you will not make any money.
To help you understand that we will give brief description of what makes up the value of an option. The premium charged by the seller of the option is made up of two main components. They are extrinsic value and intrinsic value. You as the option purchaser for the purpose of buying options on crude oil are looking for the intrinsic value of the option to increase. For the record the extrinsic value is made up of two components, time value (as the option gets closer to expiry this decays exponentially) and volatility.
The intrinsic value of the option is just the difference between the futures contract price and the option strike price. So if you believe the price is going to increase you would purchase a call option and if the futures price increased so would the intrinsic value of the option, meaning the option is now worth more and can be sold back to the market to realize the profit.
Similarly if you believed the price was going to drop you would purchase a put option. As the price drops the value of your option increases and you can sell it back to the market and realize a gain.
The maximum risk of your trade is what you paid for the option, which you know before you place the trade and can determine if it fits with your money management rules.
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