From the October 2013 issue of Futures Magazine • Subscribe!

Capturing upside on energy volatility with a butterfly spread

As of this writing the current spot price for crude oil is $108.67 per barrel. The price for the December futures contract on the NYMEX is $106.36 per bbl.  Just to show how the world has changed, in June 2008 oil was approaching $150 a barrel. Within six months the price free fell by almost 65%. Of course, that price drop was in the midst of a complete economic meltdown.

Actually, over the past three years the price of oil has been in the $80-$100 vicinity. While economic meltdowns aren’t usually telegraphed ahead of time, the markets don’t seem to be anticipating one. The drumbeats of war are once again reverberating in the Middle East. The U.S. is considering an attack on Syria, which has little oil of its own but oil exports could be curtailed if the potential conflict spreads throughout the region. A drop in supply could send prices skyrocketing.

So how can you take advantage of this price action? Of course you can buy the December futures contract at 106.36, but there would be a big downside risk should the price of oil drop, even temporarily. Margin calls would require throwing more cash into your position. Placing a stop order might take you out of your position. So to take advantage of the current energy action, a bullish options position would work to the upside while still being able to define the risk involved in the trade.

Skewed view

Let’s take a look at the “volatility skew” on options on oil futures. Volatility skew refers to the relative pricing of different options at different strike prices. The CO Dec 90 puts are trading at 0.58 while the CO Dec 123 calls are trading at 0.69. Both options are approximately equidistant from the current futures price. Because the calls are priced higher than the puts, this means options traders are implying that any upward move in the futures will happen more rapidly than a downward move. There is a slight bias to the upside in the volatility pricing although the skew is relatively flat. 

This is important because the time value in an option premium is a wasting asset. If the out-of-the-money call is priced significantly lower than the equidistant out-of-the-money put, then establishing a ratio spread that is net short calls (long the lower strike price and short the higher strike price) would work. If the opposite is true, establishing a ratio spread that is net long calls (short the lower strike price and long the higher strike price) would work. Because the skew is relatively flat, neither of these spreads is a particularly attractive choice. 

So if you are anticipating an upward move, the purchase of a CO Dec 120 call for 0.95 ($950) would benefit from an upside move. But the risk in the purchase of a naked out-of-the-money call is the erosion of time value. The price of oil has to move up quickly enough so that the decay in time value does not outpace the added value that comes from an upward move. Selling another out-of-the-money call against the long CO Dec 120 call would reduce that risk. The CO Dec 125 call is trading at 0.56 ($560). The CO Dec 120-125 call spread can be purchased for 0.39 ($390). The maximum possible loss for the spread is less than half of the loss for the purchase of the naked call. 

The profits are capped out at $125 or higher, however. The upside breakeven point is 125.29. The maximum possible profit is $4,710 for the spread. The downside risk can be reduced even further by selling an additional CO Dec 125 call for 0.56. This 1X2 spread can be established for a credit of 0.17 ($170). There is no downside risk but above 130 the risk is unlimited. Those pesky margin people will make the trader’s life miserable as well. 

So the next step is a purchase of a CO Dec 130 call for 0.37 ($370), which  will eliminate any losses above 130. The net premium for this spread is a 0.20 ($200) debit. This is called a butterfly spread. The 120 and 130 wings are purchased against the two times sale of the 125 body. The purchase price of the CO 120-125 call vertical is reduced by selling the CO130-125 call spread against it. The profit range is between 120.20 and 129.80. 

All of the scenarios  mentioned here occur at expiration and would require a 15% up move to be profitable. If the Dec oil futures merely rose 5% within the next month, the value of the butterfly could easily double. There is an excellent risk/reward in this trade.

Dan Keegan is an instructor with the Chicago School of Trading. Reach him at dan@thechicagoschooloftrading.com.

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