Exposure to falling oil prices

It turns out, I don't have the authorizations in place to trade options in my account like I thought I did. Very frustrating, but that is not your problem. I bring it up because I tried to place an options order this morning and thought I should share my reasoning.

I tried to buy puts on USO, which is an Oil ETF. Specifically I was looking at the January expiration Put with a 33 strike price. The pricing was not as favorable as I hoped, but I was still planning on making the trade.

Why? I was trying to give myself exposure to two separate outliers (at least to conventional wisdom). First, if the Iranian protests succeed in bringing about change in Iran, that change could be a more moderate, less belligerent power in the middle east. My point really, is that I see the possibility of a much more stable middle east in the next six months. This is the macro outcome that I wanted some exposure too. I don't have any crystal ball here, but I know there is a catalyst in place right now, which means the potential for real change is there.

Second, almost everyone in the investment community I talk too is very worried about inflation, usually with comments about printing money and debt to GDP ratios attached. I have a contrarian streak so this one-sided consensus has really been getting my attention. The fear of inflation has been driving investors into commodities such as gold and oil. My view is that oil is dramatically overvalued right now considering the weakness of the global economy, but is being pushed up by inflation hedgers. While I do not have much confidence that Obama's long-term spending will cease to be an issue, I do have a lot more confidence in the Fed than many investors. In my view, the Fed will be able to shrink the monetary base to compensate for the eventual increase in velocity of money. Also, I think consumer spending will be anemic for quite awhile, which leads me to be less worried about an overwhelming spike in the velocity of money. And of course, Fed Funds are basically at zero, so they have a lot of room to raise rates when the time comes. (As an aside, I do not think it is time to raise rates yet and am annoyed at investors who are calling for immediate rate increases to calm their own inflation fears)

In light of all that, I thought I would be able to buy some puts at very good prices. Unfortunately, the implied volatility in oil is also very high right now which makes oil options in general more expensive. My base case assumption was a 30% decline in oil by January 2010. Under that scenario I would have made 130%. To break even, oil had to decline 20% which was a lot more than I was expecting. Ultimately I was prepared to make the trade, but pricing made it less attractive than I thought it should be. I could just short the ETF but that gives me unlimited loss exposure and I like the idea of a fixed downside in this case.

Options trading is not for everyone (evidently not for me either according to Schwab) but mostly I wanted to share the thought process. If you make a trade like this, understand that you will lose the entire upfront cost (100% loss) if oil doesn't go down so this needs to be money you can afford to lose. That is probably obvious, so I'm sorry I insulted your intelligence.