How to Short Oil Using Futures, Options, and ETFs

Short selling is a financial strategy where an investor aims to profit from an asset’s price decline. This approach allows market participants to generate a return when they anticipate that an asset, such as crude oil, will decrease in price. Applying this strategy to the volatile oil market means actively positioning oneself to benefit if crude oil prices are expected to drop. This provides a mechanism to seek returns regardless of whether prices are increasing or decreasing.

Understanding Short Selling Mechanics

The process of short selling begins with borrowing an asset, such as shares of a company or a commodity equivalent, from a brokerage firm. These assets are immediately sold in the open market at the current prevailing price. The short seller holds cash from the sale but incurs an obligation to return the identical assets to the lender at a future date, creating a “short” position.

The strategy relies on the expectation that the asset’s market price will decline. If the price falls as anticipated, the short seller can purchase the identical asset back from the market at this new, lower price. This repurchase action is referred to as “covering” the short position, which closes the initial transaction.

Profit from a successful short sale is the positive difference between the higher price at which the assets were initially sold and the lower price at which they were subsequently bought back, before accounting for any associated fees or borrowing costs. Conversely, if the asset’s price rises, the short seller would incur a loss, as they would be forced to buy back the assets at a higher price than their initial sale.

Instruments for Shorting Oil

Several financial instruments allow investors to establish a short position on oil, each with distinct characteristics. These tools provide exposure to oil price movements without requiring physical ownership of the commodity.

Oil Futures

Oil futures contracts are standardized agreements to buy or sell a specific quantity of oil at a predetermined price on a future date. To short oil using futures, an investor sells a futures contract, committing to deliver oil at the specified price by the expiry date. If oil prices decline before the contract expires, the investor can buy an offsetting futures contract at a lower price, profiting from the difference.

Oil Options

Oil options, specifically put options, offer another way to short oil. A put option grants the holder the right, but not the obligation, to sell a specified amount of oil or an oil-related asset at a predetermined price, known as the strike price, on or before a certain expiration date. By purchasing a put option, an investor can profit if the price of oil falls below the strike price, as they can then sell the oil at the higher strike price. The maximum loss for the buyer of a put option is limited to the premium paid for the option.

Inverse Oil ETFs and ETNs

Inverse oil Exchange-Traded Funds (ETFs) and Exchange-Traded Notes (ETNs) are investment vehicles designed to move in the opposite direction of oil prices. These funds typically use derivatives like futures contracts to achieve their inverse exposure. When an investor buys shares of an inverse oil ETF or ETN, the value of their investment is expected to increase when oil prices fall and decrease when oil prices rise. These products offer a convenient way to gain inverse exposure through a standard brokerage account.

Contracts for Difference (CFDs)

Contracts for Difference (CFDs) on oil are agreements between a trader and a broker to exchange the difference in the price of oil from the time the contract is opened until it is closed. When shorting oil with CFDs, a trader opens a “sell” position, speculating that the price will fall. If the price decreases, the trader profits from the difference between the opening and closing prices. CFDs are leveraged products, meaning a small initial outlay can control a much larger position, amplifying potential gains or losses.

Executing Short Oil Trades

Initiating a short oil trade requires access to a brokerage account that supports the specific financial instruments an investor wishes to utilize. For trading futures and options, a margin account is typically required, as these instruments involve leverage and the potential for losses exceeding the initial investment. Standard brokerage accounts are sufficient for purchasing inverse oil ETFs or ETNs, as these trade like regular stocks. For Contracts for Difference (CFDs), a specialized CFD trading account is necessary.

Futures Execution

When placing orders for oil futures, the first step involves selecting the specific futures contract, identified by the underlying commodity (e.g., crude oil), contract size, and expiration month. An investor looking to short will choose to “sell to open” a position, indicating their intent to sell a contract they do not currently own. Understanding contract specifications is important for calculating potential profits and losses. Orders can be placed as market orders for immediate execution, or as limit orders, which specify a maximum or minimum price.

Options Execution

To execute a short position using oil put options, an investor identifies the underlying oil-related asset or futures contract. They then select a put option with a chosen strike price and an expiration date. The action for initiating a short-biased options trade is “buy to open” a put option. The cost of buying the put option is the premium, paid upfront, representing the maximum potential loss for the option buyer. Factors influencing this premium include the underlying asset’s price, strike price, time remaining until expiration, and implied volatility.

ETFs and ETNs Execution

Purchasing inverse oil ETFs or ETNs is comparable to buying shares of any other exchange-traded fund. An investor searches for the ticker symbol of the desired inverse oil product on their brokerage platform. A standard “buy” order is placed for the desired number of shares.

CFD Execution

For trading oil CFDs, the process involves opening a CFD account with a provider. To establish a short position, a trader selects the oil CFD and chooses to “sell” a specified number of contracts. Each CFD typically represents a certain quantity of oil. The platform will display the current bid and ask prices, and the trade is executed based on the chosen order type.

Margin and Leverage

Margin and leverage are inherent components in the execution of futures, options, and CFD trades. For futures, an “initial margin” is the capital required to open a position, acting as a good faith deposit. This is typically a small percentage of the contract’s total notional value, allowing for significant leverage. After a position is opened, a “maintenance margin” must be maintained. If the account balance falls below this level due to adverse price movements, a “margin call” is issued, requiring additional funds. CFDs are highly leveraged, requiring only a fraction of the trade’s full value as margin, which amplifies both potential profits and losses. While buying put options only requires the premium upfront, selling options or engaging in futures and CFD trading carries the risk of magnified losses due to leverage.

Market Dynamics and Financial Considerations

Understanding market dynamics and financial considerations is important when shorting oil. Oil prices are known for their volatility, influenced by geopolitical events, shifts in global supply and demand, and economic data releases. This volatility can lead to rapid price movements, quickly impacting short positions.

Contango and Backwardation

In oil futures markets, two pricing structures are contango and backwardation. Contango occurs when the price of a distant futures contract is higher than the price of a nearer-term contract, creating an upward-sloping futures curve. Conversely, backwardation exists when nearer-term contracts are priced higher than distant ones, resulting in a downward-sloping curve. These structures can affect the profitability of holding short futures positions or inverse ETFs over time, particularly due to rollover costs.

Liquidity

Liquidity refers to the ease with which an asset can be bought or sold without substantially affecting its price. Highly liquid markets, like crude oil, typically have many buyers and sellers, allowing for efficient entry and exit from positions with minimal price impact. Low liquidity can make it challenging to close positions at desired prices, potentially leading to wider bid-ask spreads and increased transaction costs.

Financing Costs

Various financing costs and premiums are associated with different shorting instruments. For put options, the premium is the upfront cost paid to acquire the option, influenced by factors like time to expiration and volatility. In CFD trading, holding positions overnight typically incurs financing charges, often referred to as rollover, based on interest rates and position size. These costs can accumulate, affecting overall profitability.

Position Sizing

Position sizing is the determination of how much capital to allocate to a trade. This involves calculating the appropriate number of contracts or shares based on an investor’s total account size and their tolerance for potential price fluctuations. Proper position sizing helps in managing overall exposure and aligning trade size with individual financial capacity.