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Oil Price Crash in Focus – Is It Time to Sell Volatility?

Oil Price Crash in Focus – Is It Time to Sell Volatility?

Ryan Grace, Chief Market Strategist - tastytrade

Key Talking Points:

  • Crude oil prices have fallen 20% due to economic growth fears, COIVD restrictions, and more supply coming to market from the U.S. and OPEC+.
  • The price crash has driven implied volatility to levels rarely seen in history.
  • Historically high oil implied volatility could represent an opportunity to sell expensive options.

Oil implied volatility as measured by OVX (CBOE Crude Oil ETF Volatility Index) hit one of its highest levels on record this month, trading at over 100%. This is a volatility we haven’t seen since the depths of the COIVD pandemic, and a point we’ve rarely reached throughout history.

Crude Oil Volatility (1-Year)

Oil Price Crash in Focus – Is It Time to Sell Volatility?

Source: tastyworks

To quantify this extreme, an annualized volatility of 100% implies an expected price range of $0 to $132, and a weekly move of just over $9.

Oil options prices suggest a market as concerned as it was during the spring of 2020 when gasoline demand fell roughly 30% and traders worried that we’d literally run out of storage space. Quite the contrary to where we stand today with total crude oil and end product stockpiles nearing the low-end of their five-year average ranges.

Crude oil has experienced a bout of weakness as both the U.S. and OPEC+ are taking measures to increase supply short term, while the sudden emergence of the COVID Omicron variant could potentially slow down economic growth and oil demand. But is this enough to warrant such extreme levels of implied volatility?

Oil has gone negative once before, so it’s not a 0% probability, nothing is, but compared to the 30%-40% range oil volatility has traded between for most of 2021, we might argue there’s a significant amount of fear being priced into the market. Maybe too much fear. This could present an opportunity to sell relatively expensive oil options.

Recently, oil volatility has been inversely correlated with price, meaning lower oil prices = higher volatility and vice versa (see below). So, selling oil volatility is likely an implicit bet on higher oil prices, but given the exaggerated nature of this vol move, we could see volatility decline regardless of price. Hence, a short oil volatility trade could present an interesting opportunity.

Crude Oil Volatility Correlations

Oil Price Crash in Focus – Is It Time to Sell Volatility?

This relative attractiveness of crude oil option premiums can also be observed when analyzing oil’s implied volatility rank. The implied volatility rank (IVR) compares the current level of an asset’s implied volatility to its range over the past year. I.e., it measures how expensive option prices are compared to where they’ve traded over a defined timeframe.

Per the IVR indicator in the tastyworks platform we can see that while volatility has come off its highs (11/26 oil fell 10% on COVID Omicron variant headlines), option prices remain historically expensive.

Crude Oil IVR Daily Range (1-Year)

Oil Price Crash in Focus – Is It Time to Sell Volatility?

Source: tastyworks

Trading Oil Volatility

If we believe elevated levels of volatility could present an opportunity to sell expensive options, we can express this view several ways. We could trade crude oil futures options or options on a crude oil ETF, such as the United States Oil Fund (USO), or even through options on energy equities which often tend to trade in line with oil prices.

Today I’ve included two trade ideas for example purposes below, both using crude oil futures options, but with varying risk profiles.

Trade Example 1: Selling Crude Oil Futures Put Option

Futures options trades carry a high risk/reward profile due to the embedded leverage in futures contracts. Each crude oil future represents 1,000 barrels of oil. This means we can calculate the notional value of the contract at 1,000 x (oil price). E.g., $66 crude oil = $66,000 in notional value. Therefore, when trading crude oil futures options we need to use a contract multiplier of 1,000 to calculate the actual risk/reward of our trade.

Below is an example of a trade where we’re selling the JAN (13D) 55 strike put option for a price of 0.50, or $500 per contract.

This option currently trades with a delta of 0.10. A 0.10 delta option has a theoretical probability of being out of the money at expiration of roughly 90%, given the present input variables used in most options pricing models. Option prices and geeks such as delta are dynamic so this can change, but presently the market is pricing a fairly high probability the price of oil is above $56 per barrel at expiration in about two weeks.

Oil Price Crash in Focus – Is It Time to Sell Volatility?

Source: tastyworks

As this trade is naked or unsecured, it carries a large amount of potential risk. To offset some of this risk, we might consider turning it into a spread by purchasing another option at a strike below the put we are selling.

Trade Example 2: Selling Crude Oil Futures Put Spread

Oil Price Crash in Focus – Is It Time to Sell Volatility?

Source: tastyworks

Compared to the undefined risk of the naked put option, a put spread carries a maximum potential loss which is quantified by the width of the spread, minus the credit received for selling the spread.

In the above example we’re selling the 55/52 JAN (13d) put spread for a price of 0.20, or $200. You’ll notice this trade has a defined potential loss of $2,800 per spread versus a maximum potential profit of $200. It also has a 90% probability of being out of the money, like selling the single 55 strike put.

This trade has a smaller maximum potential profit, though there’s theoretically less risk and the same probability of being out of the money at expiration (what we want to happen).

Conclusion

Oil is likely to remain very volatile for now but should option prices continue to trade at or near historically expensive values, I believe it presents short-term volatility traders with an opportunity to sell option premium.

Resources for Traders

Whether you are a new or experienced trader, we have several resources available to help you; indicator for tracking trader sentiment, quarterly trading forecasts, analytical and educational webinars held daily, trading guides to help you improve trading performance, and one specifically for those who are new to forex.

---Written by Ryan Grace, Chief Market Strategist at tastytrade

You can follow Ryan on Twitter @tastytradeRyan

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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