New York – So You Want to Be an Oil Speculator?

New York – You don’t need a huge pot of bailout money to trade oil these days. Just don’t expect to make the big bucks without one.

In the past year oil has traded above $120 per barrel and below $50 per barrel, generating plenty of buzz (even within government agencies like the Commodity Futures Trading Commission) about oil speculators and their mysterious ways of making mounds of money.

So who are these traders who cryptically buy and sell oil contracts for pure profit, without supplying it or using it? Most people immediately think they’re hedge funds but forget about the investment banks. Then again, you don’t have to be a hedge fund or an investment bank to be an oil speculator. Be forewarned, though: trading oil futures is not like trading stocks and bonds. It’s not for the ordinary investor. It’s a wild ride. If you’re willing to take the risk, here’s how you might go about it:

First, you’ll need money. How much? Let’s say you want to trade one contract of crude oil on the New York Mercantile Exchange (NYMEX). Since you’re not a member of the exchange, and no one will really trust your new oil venture, you’re going to need to start with at least $10,000 in your margin account (similar to a brokerage account, but it lets you leverage your bets to the hilt) as collateral to comfortably trade one contract. That might sound like a lot for just one contract, but a single contract on NYMEX represents 1,000 barrels of crude oil: if the price moves $10 per barrel, you just had a swing of $10,000 in your account, which means you’ve either doubled your money or lost your shirt, your dreams wiped out in mere minutes. And you thought casinos had all the action!

Next, you need to find a broker and clearinghouse to connect you with the markets to trade and also act as insurance to the exchange that you will cover any potential losses.

Finally, are you ready to monitor the oil market 24/7 — to be peeking at your monitor even while kissing your spouse — and are you well stocked with ulcer medications? Yes, it is that easy. Now for the hard part: profit.

The oil-futures market is like a perpetual roulette wheel: red or black, up or down … in the end, you’re just betting on the direction of prices. And just as in roulette, the house will hold an advantage. In this case the house effectively consists of big players like Goldman Sachs who own supercomputers that can easily stay one step ahead of your moves. Also, since you’re not a big player the action is going to come at a steep cost. You’ll pay more in exchange fees and commissions than the big boys, and get less profitable prices, buying slightly higher and selling slightly lower than they get to do.

O.K., it’s time to trade. So where do you start? With a clear idea of what you’re trading: you’re not trading oil. You’re trading a contract obligating you to buy or sell it at a specified delivery date in the future. But don’t worry: as long as the number of contracts you buy equals the number of contracts you sell, you won’t have to worry about the physical barrels of oil.

So how do you make money? If you sell oil at, say, $66 per barrel, and buy it back at, say, $65 per barrel, you keep the $1 per barrel difference. On one contract, or 1,000 barrels, that comes to $1,000. Not bad for a hard day’s work. But take the other side of that trade — buy for $66 and sell for $65 — and you’ve lost a grand per contract. Remember that on both trades, you’re going to pay high transaction fees and commissions, and you’ll likely be forced to take a worse price in order to guarantee that your trade executes. In all, you’ll probably give up at least $20 per contract. That adds up, and can easily eat away at any potential profits. If you made one trade per day, you’d be losing 1% of your account value per week just on fees and slippage. At least at the roulette wheel they bring you free cocktails when you’re hemorrhaging cash.

What, you have a brilliant plan to just buy and hold oil? Don’t count on it. The bigger players know what you’re thinking, and they’ll drive the price temporarily down so you are forced to sell at a lower price — or risk losing more than you can afford. As the price falls, and all of the other “smart” traders around you are forced to unwind their long positions and sell oil, the price will fall even faster against you. Why would the big boys do this to you? Well, any money lost by one trader must be gained by another. If they can make you take a loss, it ultimately translates to their gain.

The oil-futures market is a zero-sum game. When you trade oil futures, all you’re really doing is exchanging cash with other traders. You’re all betting with each other on the price of oil … except it turns out that your bets, in turn, determine the price. It’s a bit of a catch-22, but that’s the market for you.

In the end, you’re not going to fare very well. It’s the old gambler’s-ruin problem: you can only lose so much and you’re not likely to keep making money indefinitely, so you’re going to get wiped out eventually. But some players are big enough to triumph. They have low trading fees and get the best prices on their trades. They’re the ones definitively moving prices. It’s not the small speculators that we should be worried about. It’s the larger speculators, like the investment banks. Because they don’t even have to worry about getting wiped out — they get bailed out.