Volatility and two-sided action have returned to the oil market. After months of torture and mounting evidence that oil bulls were all but eradicated, they finally made an appearance.
And boy was it memorable.
The United States Oil Fund LP (ETF) (NYSEARCA:USO) rallied 24% — in a mere three days mind you — before the bulls’ vigor finally waned. And wane it did. By day’s end yesterday, USO had fell some 10% from Tuesday’s peak revealing that the road ahead will be anything but easy for oil buyers.
These recent developments in the oil market should excite opportunity seekers for a couple reasons. First, two-sided action lends itself to more tradeable setups than a market that is falling day after day after day. Sharp rallies and steep declines provide more inflection points to trade against.
Second, the massive moves in oil this week further inflated option prices in USO. Option sellers can now receive more premium than at any time in the past couple years. The CBOE Oil VIX spiked to 63 yesterday — a level not seen since late 2011.
Strangling Oil Volatility
Traders lacking a directional bias on the USO ETF, but interested in taking advantage of the elevated option premiums could consider selling strangles. The short strangle is designed to exploit range-bound action in a security as well as a decline in implied volatility. The trade is structured by selling an out-of-the-money put and an out-of-the-money call in the same expiration month.
Sell the March $16 put and the $22.50 call for a net credit of 87 cents or better. The max reward is limited to the initial 87 cent credit and will be captured if USO remains between $16 and $22.50. If we subtract the net credit from the short put and add it to the short call we can calculate the expiration break-even points. The lower break-even is $15.13 and the upper break-even is $23.36.
The elevated volatility is giving the short strangle a large profit range.
The risk for a short strangle is theoretically unlimited, but can be whittled down to a $150 or so if you exit when USO reaches either break-even point.
At the time of this writing Tyler Craig was short puts on USO.
