In October, West Texas Intermediate crude oil dipped below $90 per barrel for the first time in 18 months. From February of 2012 to October of 2014 crude was tethered to the $100 level, occasionally rising to $110 and dipping to $90, but remaining roughly inside that $20 range.
Crude oil has seen a steep drop since the summer of 2014 that only accelerated once to break the $90 per barrel support level. There are three major reasons for the drop: A massive increase in the supply of both natural gas and crude oil due to the fracking revolution; slackening world demand for oil due to the weak European economy; and the slowing Chinese economy paired with a corresponding strengthening in the U.S. dollar. As a result, Saudi Arabia lowered prices and decided against advocating for lowering the Organization of the Petroleum Exporting Countries (OPEC) production levels to protect market share. The hope was that even lower prices would break the backs of the fracking producers.
We can trade options on either crude oil futures or on an oil stock. The March futures are trading around $48 with the Mar 440 puts trading at 1.16 while the March 520 calls are at 1.60. The June futures are trading at 50.66 with the June 40 puts at 1.52 and the June 61 calls at 1.62. Chevron (CVX) is trading at $108.21 with the March 80 puts trading at 0.41 while the March 135 calls trading at 0.04. The June 135 calls are trading at 0.23 while the June 80 puts are trading at 1.13.
When the out-of-the-money (OTM) calls trade higher than the OTM puts equidistant from the stock price that means that the smart money is betting that any upward moves in the underlying will be much more rapid than a downward move. When the same OTM puts trade higher than the OTM calls, that indicates the smart money is betting that any downward moves in the underlying value will be much more rapid than an upward move. The options on March futures imply that the upward moves will be more rapid, while the options on June futures have a flat skew that implies that any move to either the upside or downside will be roughly equal in its velocity. The CVX options in both March and June are positively skewed to the downside and negatively skewed to the upside.
The price action for CVX over the past year has been loosely correlated to both the broad market (SPY) and crude oil. On Feb. 5, 2014, CVX, crude and SPY traded at $109.27, $97.38 and $173.17 respectively. On June 24 their respective prices were $135.10, $106.03 and $196.30. On Oct. 15, after crude began its slide, their respective prices were $109.50, $81.78 and $181.92 respectively. Sixteen days later their respective prices were $120.17, $80.54 and $201.82.
Since June 24, crude prices halved while CVX has dropped only 20%. SPY has risen slightly less than 3% during that time period. What’s a good options strategy in light of all of this information?
A 1X2 over-the-counter call ratio spread. The CVX Mar 115 calls are trading at 1.70 while the Mar 120 calls are trading at 0.67. The Mar 115 calls have a delta of 28 while the Mar 120 calls have a delta of 14. Each equity option potentially represents 100 shares if it is exercised. Delta measures the percentage chance of an option being exercised. That means if you are long 10 Mar 115 calls, you have an equivalent share position of 280 long shares of stock.
Let’s say that you buy 10 Mar 115 calls and sell 20 Mar 120 calls. Your equivalent share position is zero because of the disparity in deltas. At expiration, this position would lose $360 at 115 or lower, plus fees and commissions. The upside breakeven point is $124.64. Anything above that point will result in losses and leave you naked short. The sweet spot at expiration would be just under $120 where the position would net $4,640, a roughly 12 to 1 profit/loss ratio (assuming you exit short calls in case of a rally). That price means that the maximum value in the 115 calls is reached while the 120 calls still go out worthless (see “Tiger in your tank,” below).
If crude does rebound CVX should catch up to SPY on a relative basis. You can afford to be net short options, because CVX will not snap back as radically as crude will. If CVX does start to move too rapidly then buy some of the Mar 125 calls or some shares of CVX. Even if CVX doesn’t reach 115 by expiration, if it starts moving in that direction, soon enough the spread will be profitable.