by Tyler Craig | March 26, 2012 6:45 am
The equities market was been fairly tame on Friday, with both the Dow and the S&P 500 moving less than one-third of one percent. Crude oil, however, was on the move, rising almost 1.5% on the day.
In response to reports of an expected drop in Iranian oil exports, crude surged to more than $108 in morning trading before closing just shy of the $107 level. The popular United States Oil Fund (NYSE:USO) followed crude higher, closing up 1.3% on the day. Friday’s action provided yet one more example and reminder that the risk in crude is to the upside.
So what’s the play in the oil patch? One strategy that has proved quite lucrative over the past six months has been selling out-of-the-money put options. The short-put strategy’s consistent success can be attributed to its ability to profit from a drop in implied volatility (short vega) along with mildly bullish (positive delta) movement in oil. Since October 2011, the USO is up over 33% while implied volatility on USO options is down 50%. That’s a great combination for this kind of options play.
Although the “easy” short-volatility trade may have run its course, 30-day implied volatility for USO options remains slightly elevated relative to recent historical volatility. Couple this with oil’s reticence to fall beneath $105 and you have a fairly compelling environment for another short put play.
When selling out-of-the-money puts, traders are essentially betting the stock will not fall to the strike price. If correct, the puts expire worthless, allowing traders to keep the original credit received at the trade’s inception. If by chance the stock does fall below the strike price placing the put in-the-money, traders are obligated to buy shares of the underlying at the strike price.
A brief survey of the current out-of-the-money puts yields a couple of possible candidates. Consider the following two ideas:
1. Sell to open the April 39 puts for 52 cents or better
2. Sell to open the May 38 puts for 75 cents or better
The short April puts are the more aggressive bet since they are closer to expiration (25 days versus 53) and closer to the ETF price of $40.69 (Friday’s close). The April put is 4.2% away from the USO price; the May put is 6.6% away. Either way, a bit of a drop in the ETF would be required before the corresponding put is in the money. The USO has not traded below the 39 level since mid-February.
If USO does pullback, the short April put will accumulate losses quicker than the May put. On the other hand, this put will also rack up profits quicker, so consider them a higher risk/reward alternative to their May counterpart. As of Friday’s close, the April put’s delta is 26 and the May put’s delta is 25.
At the time of this writing Tyler Craig had short puts on USO.
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