Why Volatility Is Good (and Bad) for Oil Trades

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If we were to choose one word that best describes the current market environment, it would be “volatile.”

Volatility has been the hallmark of this market for the past two weeks. Whether you are measuring it in terms of the 1,000-point swings we have seen on the Dow Jones Industrial Average or the ramp above 50 we witnessed on the CBOE Volatility Index (VIX), volatility has been on the rise.

Even oil prices haven’t been able to escape the influence of volatility’s broad reach. As you can see in the hourly chart of West Texas Intermediate (WTI) oil prices below, oil had been steadily declining since late July — dropping by nearly 25%.

oil-prices-volatility
Hourly Chart of Oil Prices (West Texas Intermediate)

However, in the space of a week, oil regained all of its losses, rising from $38 per barrel all the way back up to $49 by the end of August.

Of course, in the few trading days we have had so far in September, oil has fallen back down to $44 per barrel — a drop of 10% — and the potential for further declines is on the horizon.

So why the extreme volatility?

We believe it is due to two primary factors that can be applied virtually across the board in today’s financial markets.

Factors Delivering Higher Volatility

First, there are one or two big players that seem to have an outsized impact on the market. In the oil market, those big players are Iran and Saudi Arabia — and to some extent the rest of the Organization of the Petroleum Exporting Countries (OPEC).

Last week, Saudi Arabia made noise about potentially scaling back production in an attempt to lift oil prices, and oil shot higher. This week, President Obama has gotten support for his Iran nuclear deal — which would once again give Iran, with its massive oil reserves, access to the global oil market — and oil dropped back down.

Similarly, in the stock, commodities and currency markets, the big players are the Federal Open Market Committee (FOMC), the European Central Bank (ECB) and the Chinese government — often via the People’s Bank of China (PBOC). As these entities set monetary policy, move the value of the U.S. dollar (USD) and intervene to stimulate financial markets and their economies, stocks bounce back and forth — as do commodity and currency prices.

Second, traders are overweighted and leveraged, which leaves them susceptible to squeezes and margin calls. Because oil has been trending lower so consistently for so long (it started its decline in late June of 2014), traders have had a long time to build up bearish positions. The further oil fell, the more bearish traders became, and soon they were overweight bearish.

Any time the pendulum swings too far in one direction or the other, the chance that it is going to come swinging back even faster in the opposite direction increases, because everyone is looking to exit at the same time. This phenomenon gets exacerbated when traders are leveraged in their trades, because they may not have as much discretion over when they buy and sell if they are being squeezed out of their trades by margin calls.

The volatility we have experienced during the past few weeks has been a wake-up call for many, and with the VIX still above 25, it seems that most traders are still on high alert. Nobody seems to be as confident in their assessment of the future as they were a month ago.

Thus, volatility is likely to be a part of our lives for the foreseeable future.

This is both good and bad for us as option traders. It is good because it gives us a variety of trading opportunities. It is bad for us because it means implied volatility levels are likely going to remain high, which makes buying long calls and long puts more expensive.

InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.

You can learn more about identifying price patterns and using them to project how far you think a stock is going to move in their Advanced Technical Analysis Program.

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Article printed from InvestorPlace Media, https://investorplace.com/2015/09/why-volatility-is-good-and-bad-for-oil-trades/.

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