Selling Premium on the Uncertainty in Oil

The inverse relationship between oil prices and equity markets still seems intact: as crude has sold off over the past week, markets have lifted, and some analysts have even tried charting an hour-by-hour mapping of the correlation.  While we’re long-term bullish on oil (how could anyone not be?), we don’t anticipate an immediate or intense turn around in crude prices.  At the same time, while the price of oil could certainly drift a bit lower, we don’t foresee any catalysts that would warrant a dramatic decrease.

The Thesis

In other words, we’re relatively neutral on the price of crude over the short term.

At the same time, we’re seeing implied volatility in near-term options hit new highs.  The attached chart plots the 30 day implied volatility in the options of the United States Oil Fund (USO), which isn’t an ideal proxy for crude oil, but is close enough for our purposes.  You can see basically the same story in the Energy Sector SPDR ETF (XLE), the Oil Service Holders Trust (OIH), or in individual oil names like XOM or VLO.

Traders who have booked amazing paper profits on the price runup in oil are likely just as long-term bullish as we are, and may not wish to exit their core holdings here; at the same time, recent activity in the options market suggests those traders have seen an increased need to hedge those core holdings.  Along with new highs in implied volatility, we are also seeing put/call ratios across the energy sector suggestive of some significant concern (i.e., put-buying).

The Trade

So with no short-term directional bias, and higher than normal implied volatility, a market-neutral, short-vega trade like an iron condor might not be a bad idea (we’ve had some positive, if overly exciting experiences with iron condors on the energy sector in the past).   We’ll use USO as our underlying since the options there are more liquid than in some other instruments.  With only 22 days remaining in the August expiration cycle, we would normally look to the following month; but in this case we don’t necessarily want to commit to a longer period, so the August series should work well enough.  So we would open the following position:

Day limit order
Buy to open USO August 86 put
Sell to open USO August 88 put
Sell to open USO August 113 call
Buy to open USO August 115 call

for a net credit of $0.50 or better.

Analysis: The breakeven points on this trade are $87.50 and $113.50. This trade has basically no delta bias. Our breakeven point on the call side would tolerate about a 12% move up from where USO currently sits, while the put side breakeven point is over 13% away.  Implied volatility in the USO August ATM options is currently at 42%.  This trade has about a 70% probability of expiring worthless, which would be a 33% return on capital risked.  As for exit strategies (ahem, it always helps to have a viable exit strategy when you’re doing anything involving oil, whether in trading or in real life), we would keep tighter reins on a position like this - this sector tends to move pretty deliberately, so if the trade goes bad it will make more sense to make an early exit to preserve capital, rather than hanging around hoping for a reversal of some kind.  Obviously, if things go as planned this is basically a fire-and-forget kind of trade.

Disclaimer: As always, bonus trades are provided for educational and entertainment purposes only, although to be honest, if you are entertained by blog posts such as this one, you should consider getting out more.