Learn to Embrace Volatility’s Tipping Point

by Tyler Craig | August 18, 2011 12:37 pm

Over time, I’ve adopted a multi-faceted approach to the markets which leans heavily on charting and volatility analysis.  The ideal setup occurs when both are in alignment, providing me a one-two combo of confirmation. 

When faced with conflicting signals, I must make a choice:  Do I yield to the method of analysis which I perceive offers the stronger signal?  Or do I respect the conflict and settle for the safety of the sidelines? 

In a recent opportunity arising in the oil patch, I opted for the latter, but hindsight bias has me questioning my actions.  I’m wondering if I passed up a “better” decision on my way to a “good” one.

Given the relatively consistent bullish behavior of oil in recent years, I’ve been a fan of selling puts on the United States Oil Fund (NYSE:USO[1]).  With a few exceptions, it’s been a profitable approach.  Though I’ve attempted to employ this campaign on a monthly basis, I’ve generally avoided selling puts when the USO was in the midst of a downtrend.  The thought, of course, is that if the trend is likely to continue, there is no sense jumping into a non-bearish bet like short puts.  That’s why I exited my short-put position in early August and have yet to re-enter.

Here’s where the conflict comes in:  The recent selling frenzy in black gold and subsequent mad dash into the options market lifted implied volatility for USO options to levels not seen since the mass oil liquidation of 2008 and early 2009.  Unlike the CBOE’s Market Volatility Index (VIX), the Crude Oil Volatility Index (OVX) blew way past flash-crash levels.  Such a spike presents all sorts of opportunities for short volatility-type plays like short puts.  Though the broken uptrend was telling me to steer clear, the elevated volatility was screaming “sell me, sell me!”

I believe there comes a point — a tipping point, if you will – when implied volatility gets so pumped and option premiums so fat that there is more than enough compensation to merit short puts or put spreads in the midst of a downtrend.  I suspect we reached such a point last week in USO. Unfortunately, my overemphasis on charting and under emphasis on volatility caused me to pass up the opportunity.

Option sellers should keep this tipping point in mind when future volatility ramps – like the one on Thursday — arise.

 craigpic818 e1313683909222 Learn to Embrace Volatility's Tipping Point

Source:  MachTrader

At the time of this writing, Tyler Craig had no positions on USO.

 

Endnotes:
  1. USO: http://studio-5.financialcontent.com/investplace/quote?Symbol=USO

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