Oil Market Begs To Be Shorted—Modestly

October 28, 2010

—For bearish investors, the secret to playing the relatively low volatility in the oil market right now lies in put spreads.

 

Sometimes you just have to deal with limitations. For example, with interest rates as low as they are, you're not likely to make big bucks off your deposit account. But the trade-off is, of course, the certainty of getting your principal back. So you accept a limited reward for a limited risk.

Bearish investors now seek a similar trade-off in the oil market as they consider put spreads.

Put options are contracts that afford their purchasers the opportunity to sell assets at a certain price, no matter what their prevailing market value. Sellers of puts undertake the obligation to buy the contract's underlying asset upon exercise.

A put spread entails the simultaneous purchase and sale of similar option contracts. In the current environment, vertical spreads—or those for which only the strike prices of the puts differ—have become particularly attractive. More specifically, bearish spreads.

For a put spread to have bearish pay-off characteristics, the contract with the higher strike price must be purchased while a lower-struck put is sold. The higher-struck put will invariably be the more expensive, so the transaction will result in a net debit, meaning more premium is paid out than received.

Debit spreads make sense now because the volatility assumption priced into oil options is relatively low. In the chart below, take a look at the red line, which represents the CBOE Oil Volatility Index. This index measures 30-day volatility expectations in a panoply of United States Oil Fund (NYSE Arca: USO) options.

 

WTI Spot Vs. Oil Volatility Index

WTI Spot Vs. Oil Volatility Index

 

Presently, the index reading is 32.00, which represents an annualized volatility of 32 percent. It's not the cheapest these options have been, but it's certainly not the most expensive, either. That high watermark was 100.42, set in December 2008; the low point was a December 2007 reading of 24.67.

Buying a put spread is a bearish play, albeit a moderate one. If you expect a modest decline in the price of the USO ETF, then a bear put spread works well for a low volatility environment.

The fund's trading at the $35 level now, so nearby strike prices would be $34 and $33. A last look at the December contracts showed a $34 put offered at $1.07 a share and a 75-cent bid for a $33 contract. Given USO's recent lows in the $31-$32 range, these puts would make a sensible spread.

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