Crude oil prices will continue to face headwinds thanks to structural issues that will keep pressuring prices. Oil producers globally are not willing to refrain from producing more oil, and U.S. supply is expected to increase by 300,000 barrels a day from current levels in 2015 according to the Energy Information Administration.
Demand could continue to fall, too, which already has led to an accelerated drop in prices and a surge in crude oil volatility. The nice thing for investors: Higher implied volatility flows directly into the prices of call and put options, and that spells opportunity.
Price action will likely remain volatile as news about strong supply and subdued demand is met with recent dovish central bank information. For example, on Dec. 12, the International Energy Agency reduced its forecast for global oil demand growth for the fourth time in the last five months. Prices dipped over the following few trading sessions, but started to bounce after the Federal Reserve made its interest rate policy decision.
In her soft grandmotherly tone, Federal Reserve Chairwoman Janet Yellen described at her press conference that the change of language used in the Federal Reserve’s statement was just semantics. This news boosted riskier assets, including crude oil, but the change in sentiment was likely temporary.
One of the easiest ways to track oil implied volatility is to use the CBOE’s OVX, which tracks the implied volatility of the at-the-money strike prices for the United States Oil Fund LP (ETF) (USO). This exchange-traded fund attempts to track the performance of West Texas Intermediate crude oil by purchasing NYMEX crude oil futures contracts held within a trust. Over the past two months, the OVX has surged to 55, which is the highest this index has seen on a closing basis since the tail end of 2011.
The implied volatility on the OVX represents the market’s estimate of how much the USO will move on an annualized basis. This means option traders believe that at a price of $21 per share, the USO could move down a whopping 55% (as low as $9.45) or up 55% (as high at $32.55) within the next year.
So current implied volatility on the USO is rich, especially relative to recent historical crude oil volatility. The volatility of the USO peaked at 39% last month and hit a floor of 28% annualized. The difference between what traders believe will happen and what has recently happened has reached a spread of 16% (55% implied volatility – 39% historical volatility), which is the highest it has been in the past year.
With oil implied volatility printing at rich levels, I recommend using options strategies that take advantage of elevated premiums. Here are three ways to do that.
Bear Call Spread
The most conservative of these strategies is a bear call spread. A bear call spread is a strategy where you are selling a call that is out of the money and simultaneously purchasing a call that is even further out of the money.
For example, you could sell a Jan 2015 $23 call for 65 cents and simultaneously purchase a Jan $26 call for 15 cents for a net spread of 50 cents. The most you could lose is $2.50, which is the difference between the calls strike prices and the premium you received. If by chance the price of the USO moved up to $27 at expiration, which is above your protective call, both options would settle in the money, triggering your maximum loss. Your breakeven price is $23.50, which is more than 9% above the current price. If the price of the USO stayed below $23, you would keep your premium of 50 cents.
A Strangle
A second strategy that has a larger payout (but additional risk) is a strangle — here, you would sell an out-of-the-money call on USO, as well as an out-of-the-money put.
With the price of the USO near $21 per share, you could sell a Jan 2015 $23 call for 50 cents and simultaneously sell a Jan 2015 USO $19 put for 50 cents. Each option is nearly 10% out of the money. Your breakeven prices are $24 and $18, respectively, which means that the USO would need to move up or down more than 14% for you to lose money during the next 30 days.
If the price of the USO stayed between $19 and $23, you would keep your entire $1 premium.
A Straddle
One of the more aggressive option strategies that you use to generate returns from elevated USO implied volatility is a straddle — here, you simultaneously sell call and put options on USO with the same strike price.
For example, you could sell a $21 Jan 2015 call for $1.20 and a $21 Jan 2015 put for $1.20 for a total premium of $2.40. Your breakeven prices are $23.40 and $18.60, which are each 11.5% out of the money.
Despite the high level of implied volatility and the robust likelihood that these strategies will be profitable, they all come with risks. When you sell a bear call spread, for instance, you limit your loss by purchasing a protective call. When you sell strangles and straddle, your losses could be substantial as the price of the USO can rise theoretically to infinity and fall to zero.
I would pay careful attention to the level of the USO if the price reached your option strategy breakeven level.
As of this writing, David Becker did not hold a position in any of the aforementioned securities.
