In this article I highlighted a chart that I saw in this article. The implication of the chart is that crude oil – at least when compared to gold – is deeply oversold and undervalued. Will that actually prove to be the case? Sorry folks, only time will tell.
But here are 3 things we can state for sure about crude oil right now:
1. The oil market has been in a free fall since May of 2015 and there is no way to accurately forecast when “the bottom” will occur. See Figure 1.
2. That being said, we can also state that crude oil is extremely oversold and that several momentum indicators may be forming a bullish divergence. See Figure 2.
3. We can also state unequivocally that the implied volatility for options on ticker USO – an ETF that tracks the price of crude oil) is at an extremely high level (which tells us that there is a lot of time premium built into the price of USO options. See Figure 3.
The high level of implied volatility in this case indicates that there is a lot fear and uncertainty in the oil market and option traders are willing to pay a lot in order to hedge the risks they perceive to exist.Figure 1 – Long-term decline for USO (Courtesy AIQ TradingExpert)Figure 2 – Possible bullish divergence for RSI and MACD (Courtesy AIQ TradingExpert)
Figure 3 – USO options implied volatility at multi-year high (Courtesy www.OptionsAnalysis.com)
Given all of this let’s look at an example of one way to play these factors.
An Example Play in USO
As always, this blog offers only “examples” and not “recommendations”. Make no mistake that what follows fits into the category of “risky speculation.” The good news is that a trader can apportion only a small percentage of his or her capital to a trade like this, so the overall portfolio risk is low.
The strategy highlighted is commonly referred to as a “Modified Butterfly spread”. The trade highlighted involves:
*Buying 4 July USO 8.5 strike price puts
*Selling 12 July USO 8 strike price puts
*Buying 8 July USO 4 strike price puts
We are trading July options for the following reason: Changes in implied volatility have a greater effect on longer-term options than on shorter-term options.
The crux of this trade is the idea that:
a) crude oil will stabilize at least temporarily, and,
b) implied volatility will decline, possibly significantly.
c) our goal is not to hold until July but to look for the first good profit-taking opportunity if implied volatility declines significantly.
The particulars are captured in Figure 4.Figure 4 – USO July Modified put butterfly (Courtesy www.OptionsAnalysis.com)
Figure 5 – USO July Modified put butterfly risk curves (Courtesy www.OptionsAnalysis.com)
*USO is trading at $8.35
*The breakeven price is $6.89 (17.5% below current price)
*The maximum profit is $892 (however, this would only occur if USO closed at exactly $8.00 at July option expiration)
*The original credit is $692 (this profit would be realized if USO is above $8.50 at July option expiration
*The maximum risk is $2,308, however, this would only occur if we are still holding the position at July expiration and USO is below $4.00 a share.
*The primary goal (hope?) for this trade is that USO will do anything other than plunge another 17.5% AND implied volatility will fall (sharply, with any luck).
*For implied volatility were to fall back into the normal historical range for USO it would have to fall roughly 40% from current levels. If you look again at Figure 4, in the upper right you will see a “Vega” of -$12.30.
This -$12.30 Vega value tells that:
*For each 1 point rise in volatility this trade will lose $12.30 based solely on an increase in volatility.
*It also tells us that for each 1 point decline in volatility this trade will gain $12.30 based solely on a decrease in volatility.
Thus, if implied volatility falls sharply from its current extremely high level, this trade could generate a decent profit more quickly, even if price remains relatively unchanged.
For the record, another sharp selloff in price would likely be accompanied by higher volatility which could generate a significant loss fairly quickly. So a trader holding this position MUST be prepared to act if the worst case scenario (sharply lower price and/or sharply higher IV) unfolds. A stop-loss somewhere below the breakeven price of $6.89 would make sense.
Figure 6 displays the risk curves for this trade if IV did in fact fall to 0.60 times its current level (i.e., 40% lower).Figure 6 – Risk curves if USO option implied volatility drops dramatically (Courtesy www.OptionsAnalysis.com)
The expiration black line is not affected. However, the other three lines “shift” to the right (i.e., higher level) and we can see that a profit of say $500 could be obtained relatively soon even without a sharp risen the price of USO.
Remember, this is not a recommendation, only an example.
The trade highlighted herein qualifies as an “advanced lesson” in option trading strategy (so congratulations if you are still reading). There is a lot to absorb and there is also a great deal of risk since this trade more or less qualifies as “trying to catch a falling safe”. However:
When implied volatility for USO options reverses to lower ground, chances are it will happen very quickly (especially if USO advances even a little in price) and the opportunity to take advantage of the current excessively high level of implied volatility may be lost.
So for a trader looking to take advantage of the current extreme IV levels in USO options (and who is ready, willing and able to cut their loss if USO drops a certain distance below $6.89), this serves as an example of “one way to play.”