USO: Make Money in Calmer Oil Waters

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Oil prices have declined slightly more than 11% since hitting their 2014 peak in June, as increasing production in the U.S. has offset unrest in Russia, Ukraine, Iraq and Gaza. Historically, geopolitical events have created unwanted volatility in the oil markets, but the generous increase in U.S. oil production in 2014 has mitigated the treat to potential supply disruptions.

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Source: ©iStock.com/Zelfit

For investors, this spells opportunity. Namely, to capture a further reduction in oil volatility, you can use an options strategy called a strangle.

Oil Prices Are Calming Down

According to the Energy Information Administration (EIA) the petroleum markets are experiencing a new dynamic where new production from shale resources in the U.S. could substantially increase global supply. While demand in developed countries have peaked, the driving force keeping the supply/demand balance equation is coming from the emerging economies of China, India and the Middle East.

Production in the U.S. has soared to a 45-year high, according to the Department of Energy which has raised their 2015 forecast by 250,000 barrels per day to 9.53 million. Increasing focus on horizontal drilling and hydrofracking in the Bakken Shale in North Dakota and the Permian Basin in Texas have led to the current energy boom.

Besides putting a cap on prices, increasing production has mitigated the external shocks historically seen in the oil market when unrest occurs.

Approximately a year ago, the combination of a coup in Egypt and the potential attack by the U.S. on Syria pushed oil volatility — reflected by the CBOE Crude Oil Volatility Index (OVX) — to 2013 highs.

This year, the combination of unrest in Russia and Ukraine and the recent Isis attacks in Iraq has not had the same effect on oil volatility, mainly because of the cushion created by increasing U.S oil production.

With more oil volume likely in the future, volatility will remain subdued for the foreseeable future.

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How to Profit on Lower Oil Volatility – USO Strangles

A strangle is an option strategy were you simultaneously sell a call option and a put option on the same product, with the same expiration date, but different strike prices. Generally, when trading an option straddle, the call’s strike price will be above the underlying asset’s current price, and the put’s strike price will be below it.

An option price is calculated by using the markets estimate of the likelihood of the strike price of the option settling in the money. To find this you would use the implied volatility of the option. This tells you how much the market thinks your underlying security will move over the course of the next 12-months.

By selling a strangle, you’re selling implied volatility — essentially, how much the market things your underlying security will move over the next 12 months.

To place a strangle trade on oil prices, you can use the United States Oil Fund ETF (USO), an exchange-traded fund that holds oil futures contracts and tracks the movements of West Texas Intermediate crude oil on the New York Mercantile Exchange.

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The risk of this trade is that implied volatility climbs, or the price of USO moves faster than what the option price would imply. The reward is the premiums you keep for selling both options — and you get that should USO’s price remain below the call option but above the put option.

When looking for strangle strike prices, I generally search for resistance and support levels that should hold if prices begin to move. The USO chart shows support levels near $33 per share on the USO and resistance at $38.

Thus, I would look at the USO Nov $37 calls, which expire on Nov. 22, 2014, and which you can sell for 40 cents, then the Nov $34 puts, which expire at the same time and which you can sell for 60 cents. The total premium received would be $1, and that would protect you should USO move as high as $38 or as low as $33 — both of which are in line with USO’s support and resistance levels.

As of this writing, David Becker did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2014/09/oil-prices-volatility-uso/.

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