Calibrating crude: A vertical call spread

May 20, 2016 09:00 AM

WTI crude oil has had a wild ride during the past nine months. On June 24, 2015, crude closed at $60.27— 40% lower than one year prior. On Feb. 11, less than eight months later, crude closed at $26.19. By March 21, crude had rebounded to $39.91 with May futures trading as high as $42.49. That’s a 50% increase in a little over a month. 

The CBOE Crude Oil Volatility Index (OVX) measures the time value of option premium. It’s called the “Oil VIX.” Like the traditional VIX, it rises sharply when there is a great deal of uncertainty or fear. When crude was trading at $60.27, the OVX was 29.26. When crude was trading at $26.19, the OVX spiked to 79.34. On March 24, crude closed at $39.49 with the OVX closing at 44.96. OVX hit its all-time high of 100.42 on Dec. 8, 2008 when crude dropped from $147 to less than $40 in less than six months during the Great Recession. The low for the OVX was 14.25 on June 2, 2014 when crude was trading at $101 (see “Negatively correlated”). 

The time value in the option premium tends to be higher when crude falls precipitously, and the premium declines when crude rebounds. Let’s measure the skew by comparing the equidistant out-of-the-money calls and puts on the Nymex WTI June futures. CLM is trading at $40.76, the June 3500 puts have a 0.75 - 0.77 bid/ask spread and the June 4650 calls a 0.70 – 0.72 bid/ask spread. That indicates that crude comes close to moving just as rapidly to the upside as to the downside. Any ratio spread that is a 1×2 or 2×3 with strikes near-the-money is inadvisable. The overnight risk would be too great. 

A better play would be a July 4450-4600 vertical call spread (CLN). The 4450 calls have a bid/ask spread of 1.15 – 1.17 and the 4600 calls 0.79 – 0.81. If you purchase three spreads for 0.36, your maximum loss at expiration would be $1,080, with crude at $ 44.50 or lower. Your maximum profit at expiration would be $3,420, with crude at $46 or higher. Your breakeven point would be $43.36. Deltas measure the probability of an option finishing in-the-money at expiration. The 4450 calls have a 33 delta and the 4600 calls have a 23 delta for a net delta of 10. 

If we add the sale of a 4600 call at 0.80 it would trim the maximum downside loss to $280. The breakeven point would be lowered to $43.10. The maximum profit would be raised by $800 to $4,220 at $46. Above $46, however, things turn against you. With the straight bull vertical spread, your short 4600 calls are matched one for one with your long 4450 calls. In the case of the ratio spread you become naked one call at $46 or higher. 

At $46 you have maxed out the value of your 4450-4600 spread at 150. You multiply150 by the three vertical spreads. That means that the upside breakeven point is $50.50. You did, however, pay 28¢ to establish the spread. That lowers the breakeven to $50.22. Should a hot war start in the Mideast, who knows what the price of crude could go to overnight? To protect against that you could purchase a 4950 call in April for $40. That would hold you over until April expiration. The spread between May and April futures is around $1. You aren’t required to hold your position until expiration. 

Vega measures the sensitivity of an option to the changes in implied volatility. The higher the vega the greater the sensitivity. If there is a greater demand for options, implied volatility rises. We have demonstrated that implied volatility tends to rise for downward moves and drop for upward moves. The vega for the 4450 calls is 53 and 54 for the 4600 calls resulting in a net negative vega position of – 57. Implied volatility is currently about 49.50. If it drops five points then there would be a profit of $285 for each 3×4 times that you established the spread. If it expands on a downward move you would not be hurt because your max loss is still $280.

About the Author

Dan Keegan is an experienced options instructor and founder of the options education site optionthinker.