Playing the Fear Percolating in Oil

by Tyler Craig | June 13, 2012 7:30 am

The recent cascade in U.S. equities pales in comparison to the bloodbath in the oil market. While the S&P 500 Index has dropped 8% from this year’s peak, the United States Oil Fund (NYSE:USO[1]) has lost 27%. Naturally, this selling frenzy has driven many traders into the options mart in search of protection. This uptick in demand has in turn pushed the implied volatility of USO options to levels not seen since fall 2011.

For those otherwise unfamiliar with volatility analysis, a brief review is in order. The principle idea behind analyzing implied volatility is to identify situations where options are potentially mispriced. In the event implied volatility appears too elevated, options are likely overpriced, and traders would be better off initiating short option strategies. Alternatively, if implied volatility appears too low, long option strategies may have the upper hand.

By continuously buying cheap options and selling expensive options, traders shift the odds further in their favor.

The notable rise in demand for USO options has led to quite the divergence between implied volatility (yellow line in the chart) and historical volatility (blue line). While 30-day historical volatility still sitting at 25%, implied volatility has lifted to 40%. The time is ripe for selling USO options in some fashion.

Whether you sell calls or puts or some type of spread position depends primarily on your directional outlook on the share price of USO. Given the magnitude of the slide that has already transpired as well as the fact that oil is approaching levels that provided support last year, one could make a compelling case that selling put options is the way to go.

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Of the strikes available in July expiration, I like selling the 29 strike put for around 70 cents or better. Consider it a high-probability bet that USO fails to drop beneath $29 by July expiration. The $70 received at trade inception represents the max reward. The expiration breakeven price comes out to $28.30.

At the time of this writing Tyler Craig had no positions on USO.

  1. USO:

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