Buying Gasoline Put Options to Profit from a Fall in Gasoline Prices

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Gasoline Prices Begin To Fall As Demand Tapers Off

Gasoline prices in the United States are slowly falling after a Thanksgiving high, according to emerging data on the fuel’s price points. But drivers should enjoy the current falling prices—because they won’t be here for long.

On Monday, the national gallon of gasoline averaged $2.465, down 3.5 cents from the previous Monday. Demand for gasoline dropped after Thanksgiving as families returned to their homes, ending a yearly road-trip season—kicking off the season of lowered demand for the fuel.

Still, GasBuddy’s pre-Thanksgiving report pegs gas prices at their highest average since 2020, the year oil prices crashed from their highs of over $100 per barrel—so the fall in prices won’t be as much as many are accustomed to.

“With OPEC deciding last week to extend last year’s agreement on oil production cuts, the future for gasoline prices isn’t as rosy,” said Patrick DeHaan from Gasbuddy.com.

“While the short term may feature more modest price decreases is many areas, as we set our sights on the months ahead, 2020 is starting to look ominous as a result of OPEC’s extension. U.S. oil inventories are already 100 million barrels lower than where they were last year as a result of the belt tightening, leading 2020’s yearly average gas price to close out at the highest since 2020. Motorists should enjoy the falling prices now because it’s likely that prices may again rise approaching the New Year as oil prices continue to show strength.”

States in the upper-Midwest saw the biggest drop in gallon prices – up to ten cents in some places.

Oil prices have been on this rise this year as OPEC reduces output by 1.2 million barrels per day in order to close the supply glut in international markets. OPEC’s compliance to the cuts has remained above 90 percent through the life of the pact, encouraging market fundamentals to recover over the course of 11 months. Last week, the bloc decided to extend the cuts through the end of 2020, guaranteeing price growth as long as members and their Non-OPEC allies continue compliance.

Put Options Under The Spotlight: When They’re A Safe Bet [And The Dangers Of Expiring Worthless]

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Last Updated on May 18, 2020

Buying put options is a bearish strategy using leverage and is a risk-defined alternative to shorting stock. An illustration of the thought process of buying a put is given next:

  1. A trader is very bearish on a particular stock trading at $50.
  2. The trader is either risk-averse, wanting to know before hand their maximum loss or wants greater leverage than simply shorting stock.
  3. The trader expects the stock to move below $47.06 in the next 30 days.

Given those expectations, the trader selects the $47.50 put option strike price which is trading for $0.44. For this example, the trader will buy only 1 put option contract (Note: 1 contract is for 100 shares) so the total cost will be $44 ($0.44 x 100 shares/contract). The graph below of this hypothetical situation is given below:

There are numerous reasons, both technical and fundamental, why a trader could feel bearish.

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Options Offer Defined Risk

When a put option is purchased, the trader instantly knows the maximum amount of money they can possibly lose. The max loss is always the premium paid to own the option contract; in this example, $44. Whether the stock rises to $55 or $100 a share, the put option holder will only lose the amount they paid for the option. This is the risk-defined benefit often discussed about as a reason to trade options.

Options offer Leverage

The other benefit is leverage. When a stock price is below its breakeven point (in this example, $47.06) the option contract at expiration acts exactly like being short stock. To illustrate, if a 100 shares of stock moves down $1, then the trader would profit $100 ($1 x $100). Likewise, below $47.06, the options breakeven point, if the stock moved down $1, then the option contract would increase by $1, thus making $100 ($1 x $100) as well.

Remember, to short the stock, the trader would have had to put up margin requirements, sometimes 150% of the present stock value ($7,500). However, the trader in this example, only paid $60 for the put option and does not need to worry about margin calls or the unlimited risk to the upside.

Options require Timing

The important part about selecting an option and option strike price, is the trader’s exact expectations for the future. If the trader expects the stock to move lower, but only $1 lower, then buying the $47.50 strike price would be foolish. This is because at expiration, if the stock price is anywhere above $47.50, whether it be $75 or $47.51, the put option will expire worthless. If a trader was correct on their prediction that the stock would move lower by $1, they would still have lost.

Similarly, if the stock moved down to $46 the day after the put option expired, the trader still would have lost all their premium paid for the option. Simply stated, when buying options, you need to predict the correct direction of stock movement, the size of the stock movement, and the time period the stock movement will occur–more complicated then shorting stock, when all a person is doing is predicting that the stock will move in their predicted direction downward.

Put Options Profit, Loss, Breakeven

The following is the profit/loss graph at expiration for the put option in the example given on the previous page.

Break-even

The breakeven point is quite easy to calculate for a put option:

  • Breakeven Stock Price = Put Option Strike Price – Premium Paid

To illustrate, the trader purchased the $47.50 strike price put option for $0.44. Therefore, $47.50 – $0.44 = $47.06. The trader will breakeven, excluding commissions/slippage, if the stock falls to $47.06 by expiration.

Profit

To calculate profits or losses on a put option use the following simple formula:

  • Put Option Profit/Loss = Breakeven Point – Stock Price at Expiration

For every dollar the stock price falls once the $47.06 breakeven barrier has been surpassed, there is a dollar for dollar profit for the options contract. So if the stock falls $5.00 to $45.00 by expiration, the owner of the the put option would make $2.06 per share ($47.06 breakeven stock price – $45.00 stock price at expiration). So total, the trader would have made $206 ($2.06 x 100 shares/contract).

Partial Loss

If the stock price decreased by $2.75 to close at $47.25 by expiration, the option trader would lose money. For this example, the trader would have lost $0.19 per contract ($47.06 breakeven stock price – $47.25 stock price). Therefore, the hypothetical trader would have lost $19 (-$0.19 x 100 shares/contract).

To summarize, in this partial loss example, the option trader bought a put option because they thought that the stock was going to fall. By all accounts, the trader was right, the stock did fall by $2.75, however, the trader was not right enough. The stock needed to move lower by at least $2.94 to $47.06 to breakeven.

Complete Loss

If the stock did not move lower than the strike price of the put option contract by expiration, the option trader would lose their entire premium paid $0.44. Likewise, if the stock moved up, irrelavent by how much it moved upward, then the option trader would still lose the $0.44 paid for the option. In either of those two circumstances, the trader would have lost $44 (-$0.44 x 100 shares/contract).

Again, this is where the limited risk part of option buying comes in: the stock could have risen 20 points, potentially blowing out a trader shorting the stock, but the option contract owner would still only lose their premium paid, in this case $0.44.

Buying put options has many positive benefits like defined-risk and leverage, but like everything else, it has its downside, which is explored on the next page.

Downside of Buying Put Options

Take another look at the put option profit/loss graph. This time, think about how far away from the current stock price of $50, the breakeven price of $47.06 is.

Put Options need Big Moves to be Profitable

Putting percentages to the breakeven number, breakeven is a 5.9% move downward in only 30 days. That sized movement is realistically possible, but highly unlikely in only 30 days. Plus, the stock has to move down more than the 5.9% to even start to make a cent of profit, profit being the whole purpose of entering into a trade. To begin with, a comparison of shorting 100 shares and buying 1 put option contract ($47.50 strike price) will be given:

  • 100 shares: $50 x 100 shares = $7,500 margin deposit ($5,000 received for sold shares + 50% of the $5,000 as additional margin)
  • 1 call option: $0.44 x 100 shares/contract = $44; keeps the rest ($7,456) in savings.

If the stock moves down 2% in the next 30 days, the shortseller makes $100; the call option holder loses $44:

  • Shortseller: Gains $100 or 1.3%
  • Option Holder: Loses $44 or 0.6% of total capital

If the stock moves down 5% in the following 30 days:

  • Shortseller: Gains $250 or 3.3%
  • Option Holder: Loses $44 or 0.6%

If the stock moves down 8% over the next 30 days, the option holder finally begins to make money:

  • Shortseller: Gains $400 or 5.3%
  • Option Holder: Gains $106 or 1.4%

It’s fair to say, that buying these out-of-the money (OTM) put options and hoping for a larger than 5.9% move lower in the stock is going to result in numerous times when the trader’s call options will expire worthless. However, the benefit of buying put options to preserve capital does have merit.

Capital Preservation

Substantial losses can be incredibly devastating. For an extreme example, a 50% loss means a trader has to make 100% profit on their next trade in order to breakeven. Also, it is important to emphasize that shorting stock is very risky, since, theoretically, stocks can increase to infinity. This means shorting stock has unlimited risk to the upside.

Buying put options and continuing the prior examples, a trader is only risking a small 0.6% of capital for each trade. This prevents the trader from incurring a single substantial loss, which is a real reality when stock trading. For example, a simple small loss from a 5% move higher is easier to take for an option put holder than a shortseller:

  • Shortseller: Loses $250 or 3.3%
  • Option Holder: Loses $44 or 0.6%

For a catastrophic 20% move higher in the stock, things get much worse for the shortseller:

  • Shortseller: Loses $1,000 or 13.3%
  • Option Holder: Loses $44 or 0.6%

In the case of the 20% stock move higher, the option holder can strike out for over 22 months and still not lose as much as the shortseller.

Moral of the story

Options are tools offering the benefits of leverage and defined risk. But like all tools, they are best used in specialized circumstances. Options require a trader to take into consideration:

  1. The direction the stock will move.
  2. How much the stock will move
  3. The time frame the stock will make its move

Oil’s plunging—why hasn’t gasoline fallen faster?

Economists call it the “rockets and feathers” phenomenon. Rockets zoom higher, but feathers float lower.

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There’s pretty wide agreement that gasoline prices seem to rise quickly when oil spikes, but they don’t fall so quickly when crude crashes. There’s little consensus about why.

The latest data point comes with the recent plunge in global crude oil prices; West Texas Intermediate has fallen from a summer peak of about $102 to just above $66 on Thursday. That’s a 35.3 percent drop.

During the same period, the average price of a gallon of gasoline has fallen from $3.77 to $2.86—or just 24 percent.

That lag in the price drop at the pump has a fairly simple explanation: The gasoline you buy today was made with crude oil bought when prices were higher. So it takes a while for the price savings to move through the supply chain.

What’s not so obvious is why prices seem to move faster to the upside when the price of crude oil rises. In technical terms, this is known as the “asymmetric, nonlinear pass-through of crude oil prices.”

Drivers call it “gasoline refiners and dealers getting greedy.”

Economists have studied the crude-gasoline price connection for decades. While they can’t agree on the causes, many studies seem to confirm that the asymmetry is real.

In 2020, a Federal Trade Commission study found that on average, retail pump prices rise more than four times as fast as they fall. The effect was more pronounced with branded gasoline than unbranded gas. And the “rockets and feathers” phenomenon was worse in Midwest cities than elsewhere in the U.S.

Researchers have sought to explain what’s going on—with mixed success. One reason the two prices don’t move in lockstep is that different market forces apply to crude and gasoline. Here’s a sampling of the answers researchers have come up with:

Competition: When gasoline prices are falling, some gas stations hold onto higher prices simply because they can. In locations where there are fewer stations competing for your business, there’s less pressure to cut prices, so they hold off as long as possible. That’s harder to do when prices are rising, cutting into already razor-thin profit margins. (Gasoline retailers typically make only a few pennies a gallon on gas, booking the bulk of their profits from the snacks and soda sold inside.)

Clueless consumers: Clemson University economist Matthew Lewis theorizes that prices seem to fall more slowly, in part, because drivers remember the last price they paid when they filled up. In spite of those 6-inch-high numerals on top of the pump, they may be slow to realize prices are falling prices until they go to refuel.

Location: Though price changes are usually tracked using national averages, the price you pay varies widely from one pump to the next. Taxes, transportation costs, local supplies, changes in commuting patterns can all act independently on gas prices, which can amplify the impact of crude price runups and crashes.

That’s why “it may not be surprising that we found more asymmetry at the local level than at the national level,” according to economists at the St. Louis Federal Reserve.

The weather: Price changes also vary widely with the season. In much of the country, refiners have to produce different blends for summer and winter months. Summer fuel is more expensive. “During the winter, the rate at which gas prices are pulled down by oil prices appeared to be higher than it was during the summer,” according to St Louis Fed researchers.

Taxes: When you top off your tank, you’re paying for more than just the cost of the gasoline. In states where taxes are high, that can be a big part of filling up. When gas prices rise, you pay extra for the gas, When they fall, you still pay the full tax, which are levied per gallon rather than per dollar. So taxes skew the ratio between the price of gasoline and crude oil, researchers at the Cleveland Federal Reserve have noted.

Global demand: Until relatively recently, gasoline refined in the U.S. was sold only in the U.S. Though still a small share of production, the volume of U.S. exports is rising as U.S. demand has shrunk. That’s helped cushion the downward price pressure from falling crude prices.

(CORRECTION: This story has been updated to correct the percentage drop in gasoline prices.)

Why Are Gas Prices So High?

When Else Have Prices Been as High

Image by Theresa Chiechi © The Balance 2020

For the week of April 29, 2020, the U.S. regular gas price was $2.76 a gallon according to the Energy Information Administration. That’s a 30% increase over the $2.12 a gallon listed for the week of January 7, 2020. That’s lower than the $2.85 a gallon for prices last year. Gas prices typically rise in anticipation of higher demand in the summer driving season.

High gas prices are created by high crude oil prices. Oil costs account for 54% of the price of regular gasoline. The remaining 46% comes from distribution and marketing, refining, and taxes, which are more stable. When oil prices rise, you can expect to see the price of gas to eventually rise at the pump.

Three Causes of High Gas Prices

The three major causes of high gas prices are supply and demand, commodities traders, and the value of the dollar. These are also the determinants of oil prices.

Supply and Demand. Like most of the things you buy, supply and demand affect both gas and oil prices. When demand is greater than supply, prices rise. For example, U.S. shale oil producers increased the oil supply in 2020. Gas prices fell to their lowest levels in five years. But that shale oil boom reversed when low prices put many producers out of business.

Seasonal demand also affects oil and gas prices. You can expect them to rise every spring. Oil futures traders know the demand for gas rises in the summer as families go on vacation and hit the road. Regulations also require a shift to summer-grade gasoline, which is more expensive to produce. They start buying oil futures contracts in the spring in anticipation of that price rise.

Commodities Traders. Traders of commodities like gasoline, wheat, and gold, also cause high gas prices. They buy oil and gasoline at the commodities futures markets. Those markets allow companies to buy contracts of gasoline for future delivery at an agreed-upon price. But most traders have no intention of taking ownership. Instead, they plan to sell the contract for a profit.

Since 2008, both gas and oil prices are affected more by the ups and downs in these futures contracts. The price depends on what buyers think the price of gas or oil will be in the future. When traders think gas or oil prices will be high, they bid them up even higher. In this way, commodities traders create a self-fulfilling prophecy. This leads to an asset bubble. Unfortunately, the one who pays for this bubble is you at the gas pump.

The Value of the Dollar Declines. Gas and oil prices also rise when the value of the dollar declines. Oil contracts are all denominated in dollars. Oil prices rose between 2002 and early 2020 because the dollar lost 40% of its value during that time. Oil prices fell between late 2020 and 2020 in part because a strong dollar allowed the members of the Organization of the Petroleum Exporting Countries to make more money while keeping supply constant.

When Else Prices Have Been High

Here’s how different situations, from conflict on the world stage to engineering mishaps, affected the price of gasoline.

April 2020: Fears about unrest in Libya and Egypt sent oil prices up to $113 a barrel. In May 2020, as oil prices dropped, the price at the pump stayed high. Why? Commodities traders were concerned about refinery closures due to the Mississippi River floods.

February 2020: Concerns about a potential military action against Iran, by either Israel or even the United States, caused high oil prices. Second, some U.S. oil refineries were closing, according to an Environmental Impact Assessment report. Third, oil and gas prices tend to rise every spring, in anticipation of increased demand during the summer.

As a result, the prices for a gallon of gasoline hit the benchmark $3.50 by February 15, two weeks earlier than in 2020. By mid-March, the national average had jumped to $3.87 a gallon. That’s because, two weeks earlier as well, the price of oil reached its benchmark of $100 a barrel. Oil went on to hit $109.77 per barrel by the end of February, before dropping slightly to $107.40 per barrel in mid-March.

August 2020: Prices were high as a result of Hurricane Isaac, which hit the U.S. Gulf Coast region on August 28, 2020. In anticipation of the Category 1 hurricane, refineries in the area shut down production. As a result, crude oil production lost 1.3 million barrels per day. This caused the average national price of gas to jump in one day, from $3.05 per gallon to $3.80 per gallon. Prices in Ohio, Indiana, and Illinois rose even further, as the storm closed a pipeline that feeds the Midwest.

September 2020: Prices rose to an average high of $4.50 a gallon in California. That was because of a supply shortage from two causes. The first was a power outage at the ExxonMobil refinery in Torrance, California. A heat wave caused the power failure. The second was a shutdown of a major north-south oil pipeline. These came on top of East Coast refinery shutdowns due to regular seasonal maintenance.

March 2020: Iran started war games near the Strait of Hormuz early in 2020. Almost 20% of the world’s oil flows through this narrow checkpoint bordering Iran and Oman. If Iran threatened to close the Strait, it would have raised the fear of a dramatic decline in oil supply. In anticipation of such a crisis, oil traders bid up the price, which reached $118.90 a barrel on February 8. Gas prices soon followed, rising to $3.85 a gallon by February 25. These rose again in August 2020 because oil prices hit a 15-month high that summer. That spike was created by political unrest in Egypt.

April 2020: Prices rose in April 2020 because the price for domestic oil rose to $101 a barrel. The domestic oil price is benchmarked by the reference grade, West Texas Intermediate. Oil prices rose because new pipelines from the Cushing, Oklahoma storage hub lowered inventories to the lowest level since November 2009. In addition, the price of imported oil, a grade called the North Sea Brent, rose to $110 per barrel. This was caused by political unrest in Ukraine, Nigeria, and Iraq. The EIA expected average national prices of gasoline to remain at $3.60 a gallon until May.

July 2020: In California, the price at the pump increased to almost $4 a gallon in July 2020. Midwest refinery problems sent California’s oil elsewhere. Since it doesn’t have major pipelines from other regions, California had to wait for tankers with imported oil to arrive. A similar issue happened in 2020. It was just a temporary regional problem.

August 2020: Gas prices rose from an average of $2.58 a gallon to $2.62 a gallon. This spike was due to an outage at BP’s Whiting refinery in Indiana, making prices in the Midwest higher than average.

November 2020: Gas prices rose when OPEC cut production. Members agreed to reduce supply by 1.2 million barrels per day in January 2020. In response, traders bid oil prices to $51 a barrel in December 2020. That was double the 13-year low of $26.55 a barrel in January 2020. Gas prices rose for 14 consecutive days after the meeting. The national average of $2.21 per gallon was up 20 cents compared to the same time period the previous year.

August 2020: Average gas prices rose from $2.35 a gallon to $2.49 a gallon. Hurricane Harvey wiped out 5% of the nation’s oil and gas production. The Department of Energy released 500,000 barrels of oil from the Strategic Petroleum Reserve. By September 5, gas prices had returned to normal.

November 2020: OPEC agreed to keep production cuts through 2020. At a meeting of OPEC and non-OPEC oil-producing nations in December of 2020, they again cut production. On January 15, 2020, the EIA released its forecast for two major crude oil benchmarks, Brent and WTI. The agency predicts that Brent will average $60.52 per barrel in 2020 and $64.76 in 2020, while the WTI will average $54.19 and $60.76.

May 2020: Global oil prices reached $80 per barrel following the U.S. decision to pull out of the Iran nuclear agreement and reinstate sanctions. Production in Iran dropped through the end of 2020. In addition, Libya and Venezuela faced limited production. Gas prices rose to $2.85 a gallon.

Factors That Force High Gas Prices to Drop

The April to September vacation-driving season often causes an increase in gas prices. But prices fall in the winter since transportation needs and production costs are lower. This price decrease even offsets an increase in home heating oil usage for winter in northern areas of the United States.

Gas prices will drop when supply increases. There are a lot of ways that could happen. OPEC could decide to release more oil. The United States could lift sanctions against Iran. Shale oil producers could find another large deposit or create new technology.

Prices will also fall as the dollar’s value rises. OPEC can allow supply to expand since they’ll remain profitable with a rising dollar.

Most important is the impact all these factors have on commodities traders. If they believe oil and gas prices will fall, they won’t bid up futures contracts. They may even find another investment, allowing prices to decline further.

What We Can Do to Reduce Prices

The most immediate thing we can do is reduce our usage of gas by driving less or increasing fuel efficiency. The best way to increase fuel efficiency is to keep tires inflated. Urban dwellers can use public transit. Others can move closer to work to reduce commuting time.

For the long term, we can change our need for oil and gas by switching to alternative fuel vehicles.

Could these actions reduce the high price of gas? They might if they were on a sustained basis over a long period of time.

The only real way for consumers to lower gas prices is to reduce demand for gas and oil for a sustained period. But the demand for gasoline and fuel isn’t declining, and it’s unclear whether the development of alternative fuels will help. The United States consumes 20% of the world’s oil. This has increased over the last 20 years, from 15 million barrels per day to 19.69 million barrels per day. It’s expected to keep rising, at least over the short term.

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