by Tyler Craig | August 28, 2013 7:20 am
Reverberations from the war drums being beat in Washington were felt by investors in all corners of Wall Street on Tuesday. Predictably, the deep thrum unleashed a herd of bulls into the energy market, driving crude oil futures up as much as 3% to $109.32.
Oil’s tendency to catch a bid amid turmoil in the Middle East has yet again been manifest.
Strength in the oil patch spilled into energy stocks making the Energy SPDR (XLE) one of the day’s top performers. Companies like Marathon Oil (MRO), Hess (HES) and Chevron (CVX) led the charge, running well into positive territory half-way into Tuesday’s trading session.
The sloth of bears being ousted from oil found a new den wreaking havoc in the transportation space. Massive liquidation in a broad swath of airlines and other oil sensitive stocks drove the Dow Jones Transportation Index (DJT) down over 2.5%. The TRAN’s failure to launch and subsequent lower swing high have completed an ominous looking head & shoulders pattern.
Meanwhile, options on the United States Oil Fund (USO) were hyperactive, with trading well into six digits to mark the highest daily call volume since September 2012. On the International Securities Exchange, 2.4 calls traded for every put. The uptick in demand drove the Oil VIX (OVX) up over 15% on the day. The excess demand for out-of-the-money call options caused upside skew to steepen — in other words, the spread between the implied volatility levels of out-of-the-money calls versus at-the-money calls is higher than normal.
For example, on Monday, the Sep 38 call (ATM) was trading with a 21.38% IV, and the Sep 40 call was trading for with a 21.77% IV — a difference of 0.38. On Tuesday, the Sep 39 call (ATM) was trading with a 24.52% IV and the Sep 41 call (OTM) was trading with a 27.14% IV — a difference of 2.62.
To exploit the elevated upside volatility as well as profit from a neutral-to-mildly bullish move in the price of USO, you could enter a call ratio spread by buying one Sep 39 call and selling three Sep 41 calls for a net credit of 15 cents or better.
The max reward of $215 will be captured if USO sits right at the short strike price of $41 at expiration. However, the expiration reward zone covers any price below about $42.
If USO remains below $39 at expiration, all call options will expire worthless, allowing you to keep the initial 15 cents received at trade entry. If USO rises above $42 by expiration (a very unlikely possibility) then you will start losing money due to the two naked short call options. See the accompanying risk graph for details.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.
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