An Oil Options Trade with High Precision

This USO spread can be rolled for a continued payoff

Commodities markets recently have been manic with gyrations of the price of materials, metals, and energy. Given these wild fluctuations, let’s consider options trading in the United States Oil Fund (NYSE: USO) that indicates a solid probability of success.

I look at some trades this way: The development of precision high altitude bombing during World War II resulted in a dramatic reduction in casualties while inflicting devastating consequences on enemy forces. I view the sort of option strategy described below as the equivalent of high altitude precision bombing.

As is shown on the daily price chart below, there is substantial support in the region of $35.60 — $36 provided by a recent swing low and the 200-day moving average.

US Oil Fund

US Oil Fund 200-Day Moving Average

In selecting the structure of option trades, I usually like to consider the volatility environment in which we currently operate. This is important because of the tendency of implied volatility (IV) to revert to its mean. The knowledgeable trader factors this into his trades in order to put the wind at his back. Trades can be selected and constructed to benefit (positive vega trades) or suffer (negative vega trades) from increases in implied volatility. As you can see in the chart below, IV is currently in the lower quartile of its historic value for this specific underlying:

US Oil Fund Implied Volatility

US Oil Fund Implied Volatility

Given the current low volatility, let’s look at a strategy that gives us substantial profit at the 50,000 foot level and the ability to roll the trade forward for additional substantial profit. This trade is structured as a “ratio calendar spread”. Sounds convoluted but that is simply a two-legged trade in which we buy a longer dated in-the-money call and sell a smaller number of out-of-the-money calls. The trade is diagrammed below:

US Oil Fund Calendar Spread

US Oil Fund Calendar Spread

This trade can be thought of as a basic calendar spread where an additional contract of the long options is purchased. The addition of this extra contract removes the upside limit on our profitability which would exist in an ordinary calendar spread. As is often the case in option trading, this trade can also be thought of as a “first cousin” to a covered-call structure where the long in-the-money contracts serve as a surrogate for long stock. I find it helpful to think of the various option constructions as individual members of several different families. Each family has a number of “family traits” that help make sense of the large number of potential constructions available to the options trader.

One of the characteristics of this family under discussion is the “Sham Wow” factor, that is the “but wait-there’s more”. The “more” in this trade is the ability to “roll” the short calls forward as they expire or, more prudently, as they reach inconsequential value. For example, this trade would have been initiated by selling the February 37 calls at a value of around 57 cents. When these calls reach minimal value, let us say 10 cents, they could be bought back, and the USO March Calls sold to capture substantial additional premium. This process can continue for April, May, June, and July. These additional sales give the opportunity to reap additional profit for the trade.

The risks in the trade are:
1. USO breaks support and continues to sell off
2. Volatility collapses on the long leg of the trade

I have discussed both of these factors in the price chart and volatility chart above when I was developing the logic of the trade. While no guarantees exist for the behavior of either price or volatility, the current trade represents a reasonable balance between risk and probability.

As with all our discussions, these considerations are presented for educational purposes and do not represent a recommendation. This is not a solicitation nor should it be considered financial advice. I am simply trying to demonstrate how to use the knowledge of option behavior to construct trades that benefit from high probability events.

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