Slick Maneuvers - Rising Oil Prices Could be Good News for the Average Investor

As the price of crude oil soared past $70 a barrel this month on its way to eventual stratospheric heights (in the view of many market forecasters), the average investor could be forgiven for failing to see any glimmer of hope in the news. After all, from a consumer standpoint, spiraling prices at the corner gas station are sure to mean that this run-up will level an immediate blow to the wallet, quite possibly to be followed by a general increase in the prices of everything from food to airline tickets as businesses pass along their rising fuel costs to the customer. And even though someone clearly stands to make money in a market that has seen a 15% rise in price since the beginning of the year, precious little information has surfaced regarding how the smaller investor might actually get a piece of this frenzied market.

Perhaps this informational vacuum stems from the fact that commodities, on the whole, do not generally garner the same type of mainstream investment attention that equities and mutual funds do. A fair part of this invisibility from the average investor’s radar likely has to do with the level of risk associated with commodities, but $70 crude oil tends to draw the interest of even the most casual observer. So now, many previously disinterested newcomers are wondering just how they might be able to participate in this increasingly white-hot market, and the range of alternatives they come upon is often a pleasant surprise, with three main avenues for staking a claim.

The most common, straightforward means of getting into the oil game is a traditional futures contract traded on one of the major exchanges. The New York Mercantile Exchange, the Tokyo Commodity Exchange, and the IntercontinentalExchange (formerly known as the International Petroleum Exchange in London) all offer trading in different crude oil futures contracts. By pegging the price of crude to a particular level at a particular time, small investors can utilize the power of leverage offered by futures contracts to enjoy the profits associated with favorable price fluctuations.

One of the common pitfalls of futures contracts for new investors, however, is often the inability to define and, more importantly, maintain a clear investment strategy when the market begins to move. Given the sizable position that one can control for a relatively small outlay for example, a single NYMEX crude oil contract covers 1,000 barrels, or 42,000 gallons even minor price movements can result in substantial account swings, causing many nervous traders to abandon sound goals and strategies. In other words, while the potential for large gains in the futures markets is ever present, so too is the risk of loss, and therefore an honest assessment of one’s risk tolerance is advisable before taking this particular plunge.

Aspiring traders who like the concept of futures but might not have the stomach for piloting a vessel whose slight turns of the wheel can result in such wide shifts of direction may want to ply the crude oil waters in a smaller, more nimble craft known as an E-Mini futures contract. Fully electronic and trading virtually 24 hours per day, the E-Mini crude oil contract features exactly the attributes that its name implies it is simply a smaller, electronic version of the traditional crude oil futures contract. E-Mini crude oil contracts are identical to the full-fledged NYMEX contracts, except at exactly one-half the size. This miniaturization allows new investors to enjoy the same liquidity and price transparency of the industry-standard NYMEX market, but helps to limit the initial investment and, therefore, the inherent market risk. The smaller capital requirement and risk exposure often results in a corresponding psychological benefit for those new to the commodities markets as well, as trading decisions can be based on rational strategic assessments, without the anxiety and distractions associated with sizable equity swings.

A third possibility for dipping a toe into crude oil for the average investor is an option on a futures contract. Like the futures contract itself, an option takes advantage of leverage to allow an investor to control a larger position than his or her initial outlay would allow for in the actual commodity. The main difference between the two investments is that an option gives the holder the right, rather than the obligation, to purchase or sell the underlying futures contract, thus providing a number of possible strategies for managing risk level and time horizon. Retail traders are increasingly embracing commodity options as tools to add leverage, manage risk, diversify portfolios, and enhance current income.

Of course, among the three basic investment alternatives listed here, there is an endless array of potential scenarios to explore with respect to speculation on the price of crude oil. But the simple trio of futures contracts, options on futures contracts, and E-Mini futures contracts give new investors in these markets a decent place to start in determining whether there is, in fact, some good news to be had in this oil rush. Because a shrewd play in the commodities market may help to offset the damage of that painful trip to the gas station.

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