Wednesday, December 29, 2010

Low Volatility in crude...I like the strangle!

What a slow week and a half it has been. The major indices continue to make annual highs a few points at a time, which seems like daily. The volume is gone from the market but so is the fear, as measured by the VIX or volatility index. The same is true for oil, after breaking out above $90/bbl the daily range has gotten very narrow and with that the volatility has fallen off a cliff.

First lets take a look at the chart for crude:

First lets take notice of the HV, which is clocking in at 10.32, which represents at least a two year low. We have rallied some 25% off off the June lows and the fear has dissapeared. Looking at both the RSI and the bollinger bands we are either in overbought territory or we are almost there. The bollinger bands are beggining to narror and turn towards each other, indicating a larger move to come in the near future. The overbought/oversold indicators say the next move should be lower, but the 5 and 10 day moving average still indicate that the trend is higher with the 5 day trading above the 10 day moving average.

What about Implied Vol?

As of right now the best tool that I have to measure the implied volatility of oil is to use the OVX which is the CBOE crude volatility index based off the options of the USO. I did however recently read that the CME has released a new product based off of the futures contract and it will be under ticker symble OIV, which I will look at once it gets more established.

But as you can see in the above chart, we have certinaly hit a low in implied volatility and I expect that we could very easily pop back into the 30 to 35 range very easily.

How am I going to play this?

With volatility at these lows, buying premium looks very attactive to me. Which doesn't happen very often as I like to be a net premium seller. But with volatility low and mixed signals as to whether crude continues higher or lowere next...I like the idea of buying a Strangle. Since Feb crude is currently the prompt month with only 16 days left of trading in the options I decided that I wanted to use the March options to strangle crude at the 92.50 call strike and the 91.50 put strike, paying $6.70 for 10 lots.

Here is the trade at initiation:

Take note that the Mar crude contract was trading at 91.94 at the initiation of the trade.

As I said above, I believe that as we enter the new year that we will see a jump in implied volatility by 5 - 10%. Based on this assumption I used the analyze tab to increase vol by 5% and moved time out to next Friday and then 10% out to next Friday.

5% increase in vol and moved time out to next friday 1/7/2011

10% increase in vol and moved time out to next friday 1/7/2011

As far as the price slice selection, I chose the prices that I thought were the most likely targets based on the chart. My first set of targets are 90 on the downside and 94 on the upside and then 87 and 96.

Additionally I also ran the same strategy based on the same price slices but with no increase in implied vol to see what I could expect, and below is what I found:

As of right now I only plan to have this on til next friday. So I am looking at a P&L of somewhere in the following range:

-7,000 to + 25,000

I will update this post next week.


  1. So this traded ended up being short lived. We came in today with crude down a buck and Vol ticking up 3% from yesterday and the strangle was exactly where I got in yesterday.

    So rather than give it any more time to loose theta I closed it out for a scratch trade.

  2. So theoretically this should have worked right, because you got directional movement and an increase in vol?

  3. Yes theorectically this should had worked. I came in at 6:30 am this morning with crude down over $1/bbl and vol up a few percentage points. By 7:30 am when I checked the prices this thing had not moved from my entry price.

    But after DOE's were released crude dropped another dollar per bbl and vol jumped up another 3-4% for a total jump of 6.5% on the day.

    So eventually some of that caught up with the strangle which increased by about 30cts or about a $3,000 gain. But I will happily take my scratch trade as it was not what I had expected. I would had expected it to be up way more than that on a 6.5% pop in vol.

  4. After further analysis I was wrong and here is why:

    MY MISTAKE: I was looking at the % move of the OVX index and not the actual net change, it is the net change that represents the move in implied vol. So a move from 27 to 29 would be 2 full points, although the percentage move would be much greater. At the time I closed out my position the OVX was up 2% but the net change was only 0.50-0.60 (this is the number I should had been focusing on. Implied vol at this point had only gone up by about ½ of 1% in implied vol points).

    Now according to the Greeks at initiation of this trade I should had made $2,700 for every 1% increase in Vol, a loss of $710/day in theta, and a loss of $310 per 1 dollar down move. So if you take these factors into consideration this is what the strangle should had been worth when I closed it out with vol up 0.50% and crude down $1 and 1 day of theta burn:

    (2,700 * .50) – 710 -310 = $330 gain --> When I closed this position out it was 6.65 x 6.80, I went 6.70 just to increase probability of getting filled, but the mark or theoretical price was at 6.725 which would had represented a $250 gain if I tried to squeeze it out of the market makers. So in all reality it was only $50 off what the analyze tab had predicted.

    Now I kept an eye on this after the DOE’s came out and the Oil Volatility index continued to rise. At one point in the day the vol index was up 7.2% or 2.00 implied volatility points, at this point the analyze tab was showing a gain of $3,000. Now lets confirm what it should had been based on the Greeks at initiation:

    (2,700 * 2.00) -710 –(310 * 2) = $4,070 --> So in this estimate it was off about $1,000 vs what the analyze tab was showing as the profit based on my original entry of 6.70. But I think this could be explained as the market makers may have begun to price out the weekends theta.

    All in all I realized that I was looking at the OVX index wrong and for the most part the analyze tab was actually pretty accurate. I was quick to jump to conclusions, but it was worth the learning experience and I got out of it for a scratch trade. It also forced me to think through what went wrong.

  5. Taking a learning lesson with you on a scratch instead of a loss is a blessing. Most of my learning experiences cost me quite a bit.