Crude oil prices actually fell 3.1% last week despite rising tensions in Iraq and continued geopolitical turmoil in Israel. However, despite this decline, tensions pushed crude oil’s implied volatility to three-week highs.
Although crude oil prices will likely stabilize as the U.S. moves further into the summer driving season, volatility could continue to move higher, allowing investors to profit from an options strategy called a straddle.
Iraqi Production Could Be Offset by Demand
Violence in Iraq has created uncertainty over the country’s ability to continue to produce oil at its current pace. According to the Department of Energy, production in 2014 increased to 3.3 million barrels per day in May, which actually was 150,000 barrels per day better than May 2013.
In July, the Energy Information Administration reduced its forecast to 3.1 million to 3.2 million barrels per day through 2015 — and that reduction takes into account the region’s current tensions.
However, it’s important to note that a decline in production in Iraqi oil could be offset by a decline in demand, according to the EIA’s recent estimate of product supply. Over the past month, gasoline demand averaged approximately 9 million barrels per day, down by 0.4% year over year. Heating oil and diesel fuel demand averaged 3.8 million barrels per day over the past month, down by 6.2% year over year
Rising Implied Volatility
Implied volatility is the market’s estimate of how much as security might move over a given period measured on an annualized basis. The OVX Index is an index that is produced by the Chicago Board of Trade and is similar to the VIX as it measures the implied volatility of the “at-the-money” strike prices of the United States Oil Fund (USO), which holds futures contracts on West Texas Intermediate (WTI) NYMEX crude oil.
Click to Enlarge The OVX climbed higher by nearly 1% in the prior week, and is poised to test resistance near 18.85, which coincides with the 200-day moving average. Momentum also is increasing as the MACD (moving average convergence divergence) generated a buy signal. This occurs as the spread (the 12-day moving average minus the 26-day moving average) crosses above the nine-day moving average of the spread.
The OVX moved from negative to positive territory, confirming the buy signal.
How to Trade Rising Volatility in Oil Prices
If you agree that the OVX will continue to rise, one way to profit is via an options straddle on the USO. A straddle is a strategy in which an investor purchases a call and a put at the same strike price, for the same expiration date. A straddle is profitable if implied volatility rises, which increases the value of both the calls and puts.
The USO Jan 2015 $37 straddle has a bid-ask spread of $3.23 at $3.54 with a mid-price of $3.39. If the straddle were purchased at the mid-price of $3.39, the price of the USO would need to be either above $40.39 or below $33.61 for an investor to break even. An investor also can profit if implied volatility rises as oil prices gyrate.
How does this work? Well, options are valued using an option-pricing model. The model takes a number of input variables and creates a value based on the likelihood that the option will be in the money at expiration. With all other inputs remaining unchanged, the Jan 2015 USO $37 straddle with increase by approximately 20 cents per contract for every 1% increase in implied volatility. So if the OVX climbs from 17% to 18%, investors should expect their straddle to increase by 20 cents.
The risk an investor faces is that prices remain stable, time passes and volatility declines, which will reduce the value of both the call and put options.
As of this writing, David Becker did not hold a position in any of the aforementioned securities.