Tuesday, May 18, 2010

USO/IWO trade

I liked the IWO trade idea at first so I decided to analyze it further. I think the time frame used and patterns seen of chart drawing can be subjective. I'm using a lower support line than him. He never mentioned IV in his analysis and after I saw the current disparity I decided to do this trade but at a lower strike and using an exit point based on my TA. Below is my trade worksheet.

Trade Worksheet

Date:               5/18/10                       
Underlying:     USO
Trade Idea:     Sell June 32/30 put spread

Under. Price
Put Spread

Pre-Trade Analysis: 
This is more of a gut feel than anything as I feel selling in oil is a bit overdone. If oil finds a bottom near these levels in the next five weeks this play will yield its maximum return. IV is at a relative historical high so I favor selling the put spread rather than buying calls or a call spread. I’m attempting to profit from theta decay, reversion to the mean on IV, and a technical bounce on the underlying. On a technical basis I’m conflicted, depending on which time frame you look at there are different technicals present. I’m using a close below $31.50 as my stop loss as that would be another 6% drop from here and a breach of another long-term resistance from July 09’. This could confirm that my gut instinct is wrong and two recent support levels on the chart didn't hold. We just closed below recent support at $34.00 from October 09’ and Feb 10’. These price points are slightly different depending on if you’re using intraday or closing prices.


What are known risks? Oil is in at least a short-term downtrend, general weakness in all commodity classes other than metals, recent general pessimism about strength of global recovery because of Europe.

Entry Point: Sell June 32/30 put spread for .50 with USO @ $33.50
Exit Point: Exit spread if USO closes below $31.50. This should be a rough loss of -$165. However, this is only an estimate as you have overnight and/or gap risk that you can’t get out at your desired exit point. Also, BxA spreads might be wider than normal if volatility is spiking. For these reasons I assume full risk on the trade of $750.

Risk: $750      Return: $250              RoR: 33%

Post-Trade Analysis:
After initiating this trade I decided to look at another angle. If my threshold for pain on the short put spread is roughly $170, I wanted to see what kind of comparative risk/return there would be had I just used the $170 to buy calls instead. Below is the analytics on this scenario, it assumes that if we have a bounce in the underlying that IV comes down to a more recent range of about 35%. At this new lower IV range and taking off a few days, even at a price of $36 the return is only about $173. And this would still leave you with another three weeks of theta risk. So assuming you are playing for the underlying to stop falling and/or bet a bounce, I would still favor selling puts here as opposed to buying calls. This analysis however should have been done before the trade and not after.

Update: On 5/25 I closed this trade out for a loss. I might have jumped the gun a little in that my original exit point was on a close under $31.50 and we haven't yet closed below that level. However, intraday we've traded below $31.00 and also a new 52 week low (see chart below). In the 7 days since this trade was initiated the global macro news has only gotten worse. As of today my gut feel was wrong, another technical level was broken, and I wouldn't put this trade on today. So I'm comfortable closing it out today for a $225 loss rather than possibly take the maximum $750 loss three and half weeks from now. 

Profit/Loss: I sold this spread for a .50 debit and closed it out for .95, net loss of (.45 x  5 contracts) = $225 plus commissions.


  1. I really like the new analysis form. The only thing that gets me nervous about this trade is the whole debt crisis in Europe, and more specifically its effect on the Euro. Because with a weak Euro we have a stronger dollar which if the relationship holds means lower oil prices. But in your time frame for this trade you could be fine.

    I would also keep my eye on CL in addition to USO to watch the price action in Crude itself.

  2. I agree, I didn't mention the relation to the Euro but I do understand the relationship. My first iteration that got reworded before I posted mentioned that this felt a bit like trying to call bottom or catch a falling knife, that's why I'm looking to cut the trade if it continues to fall. The Euro/$ relation is a structural force that doesn't exactly show up in a chart of USO or CL. I would not expect support or resistance lines to hold given a large structural disturbance in that relationship.