How to Buy and Sell Oil Futures
- Real Vision
- July 19, 2022
- 3:29 PM
Oil is one of the most sought-after commodities in the world. It is, therefore, one of the most traded, with millions of dollars worth of black gold trading hands each day. As a result of its intricate link to sectors of the economy such as transportation, manufacturing, and energy, even the most subtle changes in supply and demand can cause significant changes in the price. This leaves opportunities to capitalize.
But for retail investors, investing in oil is not as straightforward as it may first appear. After all, how many people have a fleet of cargo ships or a warehouse ready to store a few thousand gallons of crude? This is why oil futures can offer one of the best investment solutions.
Although oil investors can also opt for oil-focused stocks or oil ETFs, the value of these investment products is only indirectly linked to the price of oil. While an indirect investment in oil does have its benefits, oil futures contracts trade much more closely to the true underlying oil price and, therefore, are more suitable for those looking to take advantage of oil price swings.
In this guide, we will uncover exactly what oil futures contracts are, what advantages these products offer, and outline three steps that will allow any investor to start trading.
Related: How to Trade Oil Options
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What Are Oil Futures Contracts?
Before understanding oil futures, it is a good idea to wrap your head around what a futures contract actually is.
Futures contracts state that the holder has the right to either buy or sell an underlying asset at an agreed forward price and on an agreed expiration date in the future. These types of contracts are used to lock in a future price of an underlying asset, such as oil. Now let’s look at how these products can be used to trade oil markets.
All futures contracts are a type of derivative product, which means that they follow the value of an underlying asset. In the case of oil futures, contracts follow the price of crude oil markets (either Brent or WTI — these will be defined in a later section). This means they can be used to capitalize on oil price movements, whether the price is moving up or more moving down.
When it comes to trading oil futures, there are only two types of contracts that an investor needs to understand: (1) long contracts and (2) short contracts.
- If a trader enters into a long oil futures contract it means that they are obligated to buy underlying crude oil on the date of expiration. The price of purchase, otherwise known as the forward price, is agreed upon entry. A long oil futures trader will profit if the market price of oil is higher than the forward price. In other words, thanks to the futures contract, the trader has the opportunity to buy oil at a cheaper price than the true market value — effectively locking in a profit.
- Alongside the opportunity to go long, traders can also open a short position if they believe that the value of oil is likely to decrease. If a trader enters into a short oil futures contract it means that they are obligated to sell crude oil on the date of expiration. The price of sale is also known as the forward price and is agreed upon entry.
A short oil futures trader will profit if the market price of oil is below the forward price. Just like the previous scenario, a profitable short futures trade provides an investor with the opportunity to sell oil at a higher price than the true market value — again, locking in a profit.
Alongside understanding the basics of short and long contracts, there are a couple of other factors that all oil futures traders need to appreciate.
The first is that, regardless of profitability, entering into a futures contract means that you are obligated to carry out the transaction. There’s no backing out if the market happens to move against you. This means futures contracts should not be entered into lightly.
Secondly, each oil futures contract is equivalent to 1,000 barrels of crude oil. This ratio was chosen to allow the uniform trading of oil futures globally. However, it does mean that it is easy for new futures traders to have a misapprehension that each contract is equivalent to 1 barrel of oil — quite an expensive mistake to make.
Do I Need To Physically Deliver Oil When Trading Oil Futures?
If you’re a retail investor looking to use oil futures to capitalize on price movements, oil futures can still be used without being held accountable for physical delivery. However, oil futures are still used by some as a method to lock in the future price of physical crude.
Historically, oil futures were used by oil producers or oil consumers as a method of locking in the price of physical crude. Oil producers could guarantee sales of expected future production, and oil consumers could guarantee adequate supply was managed. At the end of an oil futures contract, those with long contracts would buy and take delivery of oil. Meanwhile, those with short contracts would sell and deliver oil.
The important point to make here is that physical delivery is still honored with some types of oil futures contracts. Therefore, it is pivotal to check which type of contract you are trading. Even if physical delivery is expected at the end of a futures contract, a retail investor can still use the contract to trade oil prices. As long as all futures contracts are closed before the date of expiry, profit and loss are usually settled in cash.
Margin
Alongside following the price of oil more closely, another key advantage of trading oil futures contracts is that the total value of futures contracts is not usually required to open a position. Brokers that offer oil futures trading typically use a mechanism called margin.
Margin allows trades to be opened with a small amount of upfront capital. For providing collateral, brokerage firms allow traders to “borrow” the remaining value, which means that bigger trades can be opened. The amount of collateral required will depend on the amount of leverage selected.
It is important to remember that margin and leverage are a double-edged sword. While it allows traders to open larger positions, which could increase profits, it can also significantly increase losses if the trade moves in a direction you weren’t expecting.
Margin can be broken down into two key elements: (1) initial margin and (2) maintenance margin.
- Initial margin. Initial margin is the amount of money required to open an oil futures contract position. Brokers will define this as a percentage of the total oil futures contract value.
- Maintenance margin. Once an oil futures contract is opened, the second important metric to keep a close eye on is the maintenance margin. The maintenance margin defines how much money is required to keep a trade open. Importantly, if the margin falls below maintenance levels, an oil futures contract trade will start to get liquidated by the broker.
Why Use Oil Futures Contracts?
There are several reasons why oil futures contracts could be used to gain exposure to the oil markets. We have touched on a few of these already but there are a few additional advantages that are also worth mentioning.
- High-trade volume. The oil futures market is one of the most liquid in the world, which means that traders and investors can drop in and out of the market at any time with very little slippage in prices.
- Go long and short. Oil futures contracts also allow traders to profit when the price of crude oil is both rising and falling. In comparison, investors can only profit from oil-related stocks and ETFs when values increase.
- Direct oil exposure. Oil futures contracts track the underlying price of crude oil directly and, therefore, allow for direct exposure to prices. It is arguably one of the best ways to gain exposure to crude oil without having the disadvantages of physical delivery.
- Low upfront capital. Margin allows investors to open futures positions with far less capital than would otherwise be required. While this is an advantage when the price moves in the direction you expect, it can also work against you if the price moves unexpectedly.
3 Steps To Buy And Sell Oil Futures
To profitably buy and sell oil futures all investors need to have a good understanding of oil fundamentals, appreciate the specifications of each oil futures contract, choose a respectable brokerage firm, and open a trading account. While getting to the stage where you are ready to place your first trade can seem like a daunting task, the process is much more manageable when broken down into bite-sized pieces.
1. Learn Oil Fundamentals
Investing in oil futures contracts is not a set-it-and-leave-it strategy. Oil futures contracts can last from a couple of days up to 6 months, which means that these products are used to capitalize on shorter-term price movements. This means that understanding the fundamentals of oil is crucial.
Crude oil is a natural resource extracted from the ground. It is used in the production of fuels, petrochemicals, and energy. Importantly, its price is predominantly driven by supply and demand, which can be unbalanced due to a variety of factors. Changes to the global economy, instability in oil-producing countries, and geopolitical scenarios are just a few examples. An oil futures trader needs to keep abreast of all oil market news so that a position can be managed accordingly. Check out our guide for a full breakdown of what elements determine the price of oil.
Alongside an understanding of supply and demand, an oil futures trader needs to be able to track the underlying price of crude oil. The most used benchmarks for the price of oil are the West Texas Intermediate (WTI), which is used for the U.S. market, and Brent, which originates from the United Kingdom and is used in Europe and Asia. Most oil futures contracts track one of these two global benchmarks.
An example of a popular oil futures contract for WTI is CME Group’s NYMEX WTI Crude Oil Futures (CL). Likewise, the most popular oil futures contract for Brent is the ICE Brent Crude Futures (BRN). Fortunately for retail investors, both of these contracts can be accessed from a variety of brokerage accounts.
2. Understand Oil Contract Specifications
Got an understanding of oil fundamentals and know how to track market news? Good. Now it is time to understand the specifications of oil futures contracts. What is it that you are buying or selling?
Luckily the contract specifications for both the NYMEX WTI Crude Oil Futures (CL) and the ICE Brent Crude Futures (BRN) are similar, so we will use these as examples.
The contract size for both CL and BRN is 1,000 barrels. In other words, for each contract, a trader commits to either buying or selling 1,000 barrels of oil. This means that for every $0.01 price move (equivalent to 1 tick) the contract value will change by $10. For every $1 price move, the contract value will change by $1,000.
In addition to the contract size, it is also important to check the expiry of each contract. Are you entering an oil futures trade for a couple of weeks or for a couple of months? If you expect prices to rise above $50, how long do you think it will take prices to get there? The contract length of an oil futures contract can be just as important as the entry price. Both CL and BRN contracts expire on a monthly timeframe.
Finally, as mentioned previously, some oil futures contracts are physically delivered. The NYMEX WTI Crude Oil Futures contracts fall into this category. This means that unless a futures contract is previously cash-settled, physical oil needs to be purchased or sold on the date of expiry. In comparison ICE Brent Crude Futures and the WTI equivalent, ICE WTI Crude Futures, are cash-settled, meaning that the risk of physical delivery is removed.
As NYMEX and ICE are two different exchanges, the trading hours between the two will differ.
3. Pick A Broker And Open A Trading Account
The final step in the process is to find and open a brokerage trading account that supports oil futures. There is a huge variety of brokerage platforms out there and while many offer oil futures, the way that those products are packaged may be slightly different. Remember to check the platform’s fees, the security procedures implemented, and the market spread.
Once you think you have found a suitable brokerage, next it is time to open a demo account. Opening an account that lets you trade with virtual currency will allow you to gain an appreciation for the different futures contracts offered and become familiar with any margin requirements. A demo account will also help you to see exactly how the platform works. Many demo accounts can be opened with basic personal information and an email address.
After you have tested a platform with virtual currency, the final step is to open a real funded account. This will likely require slightly more Know-Your-Customer (KYC) documentation, such as proof of address and residency. Once an account is created, funds can usually be deposited via bank transfer.
Follow these three steps and you should be more than ready to start placing your first oil futures trade. Learn those fundamentals, develop an investment thesis, and don’t forget to keep your finger on the pulse of oil market news.
What Are The Risks Of Oil Futures?
Before rushing to open a brokerage account, it is important to assess the downsides involved with trading oil futures. For all the advantages on offer, there are also a few risks that are worth considering:
- Volatility. The oil markets can be extremely volatile and unpredictable, particularly during times of market uncertainty. News can be released at any time of day and can cause wild price fluctuations in oil futures. Most traders will react instantly rather than waiting to see real-world outcomes, which means that during those times, the market is traded on emotion rather than logic. Wild price swings can quickly eat into the margin requirements to keep an oil futures trade open. If a trader is not paying attention to active price moves, positions could become liquidated. This is why trading oil futures is much better suited to active investors that are likely to check price moves and market news on a daily basis.
- Overleveraging. As oil futures contracts can be traded with margin and leverage, it is also very easy for investors to overleverage a position. When placing a trade, it can be tempting to increase leverage and therefore, increase a position size without increasing the initial margin. However, if the trade moves against you, losses can be significantly higher.
- Physical delivery. Oil futures contracts are a promise to either buy or sell a certain number of barrels of oil. While most futures contracts are cash-settled, some aren’t, which means there is a risk of getting lumbered with physical delivery. Although extremely unlikely, it is still a risk that should still be considered.
The Bottom Line
Oil futures are extremely useful for shorter-term traders that wish to capitalize on price swings in the oil markets. Oil futures markets track the underlying price of crude oil closely and are one of the most liquid markets in the world.
However, oil futures contracts should not be considered for those looking for a set-it-and-forget-it strategy. Like stock traders, the best oil futures traders have their fingers consistently on the pulse of market news, which is why trading oil futures is still considered an advanced form of investing. All oil futures traders should feel confident with contract specifications and how to use a specialized brokerage platform. However, with a key understanding of oil fundamentals and a strong trading strategy, oil futures can prove to be extremely lucrative.