Tap into oil volatility using an options spread

Crude Oil – High or Low?

Over the past week crude oil prices have been rocked by conflicting macroeconomic data and a suspected price-fixing scandal, and the resultant price swings have left many investors questioning the validity of the current price levels. As you would suspect, there is no consensus as to whether oil is over, under or properly valued at current levels, though the concern over a price-fixing scandal seems a likely factor to potentially affect the market in the immediate term.  Unsteady but generally upward-trending economic data should (in general terms) correlate with an increased global demand for oil, but increased output from the United States likely will drive prices down in the long-term. 

The United States recently reported declining oil stocks, but stocks in Cushing, Okla. have begun to climb sharply after two periods of decline.  Increased reserves in Cushing signal increased American production, likely resulting from a progressively more robust shale oil industry.  Recent macroeconomic data also has placed pressure on crude, as European, American and Chinese manufacturing and consumption numbers have been erratic in recent reporting periods. 

Crude prices very likely will whipsaw in the near-term.  The market is nearly impossible to pin down, despite the probable results of the current positive supply shock and the uncertain demand numbers, the oil market tends toward unpredictability.  Currently, crude is in the midst of an early rally, but in the upcoming weeks and months it would not be surprising to see the average price of oil driven down as the United States’ and Canadian oil renaissance enters full tilt.

So it is clear that the near term price action is likely to be volatile with a slight downward bias. I want to look at a trade to the short side that also could benefit from increased volatility. The options market is implying a downside target of $89.05 by July expiration. I want to look at a slightly more conservative target.

Trade:
Buying the /CL Jul 90.5-89.5 Put Spread for $0.20
Risk: $200 per 1 lot
Reward: $800 per 1 lot
Breakeven: $90.30

This trade gets me short crude with a great risk vs. reward ratio at a price target that is more conservative than what the market is implying.

About the Author
James Ramelli

James Ramelli is the Moderator of the Live Futures Options Trading Room at KeeneOnTheMarket.com where he actively trades futures and options on futures while educating members on strategies, setups and risk management. He has a degree in Finance with a focus in Derivatives Trading and Financial Engineering from The University of Illinois and has been trading for five years. James appears regularly on Bloomberg T.V. and BNN and writes a weekly column for Futures Magazine.

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