Oil Volatility and How to Profit From It

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Oil Volatility and How to Profit From It

The current volatility in oil prices gives an amazing chance for traders to earn if they can correctly forecast the direction of the market. Volatility is defined as the predicted change in an instrument’s price in either direction. For example, if oil volatility is 15% and current oil prices are $100, traders estimate oil prices to vary by 15% over the next year (to either $85 or $115).

If the present volatility exceeds the historical volatility, traders anticipate increased price volatility in the future. If current volatility is lower than the long-term average, traders anticipate reduced price volatility in the future. The Cboe Crude Oil ETF Volatility Index (OVX) analyzes the implied volatility of at-the-money strike prices for the U.S. Oil Fund ETF. The ETF invests in NYMEX crude oil futures to follow the movement of WTI Crude Oil (WTI).

Buying and Selling Volatility

Using derivative methods, traders may profit from unpredictable oil prices. These primarily consist of purchasing and selling options at the same time, as well as placing positions in futures contracts on exchanges that provide crude oil derivative products. A “long straddle” is a technique used by traders to purchase volatility or benefit from an increase in volatility. It entails purchasing a call and a put option with the same strike price. If there is a significant shift in either the upward or downward direction, the approach becomes lucrative.

For example, if oil is trading at $75 and the at-the-money strike price call option is trading at $3 and the at-the-money strike price put option is trading at $4, the strategy becomes lucrative if the price of oil moves more than $7. As a result, if the oil price increases over $82 or falls below $68 (without brokerage fees), the strategy is profitable. This strategy may also be implemented using out-of-the-money options, sometimes known as a “long strangle,” which decreases the initial premium expenses but requires a bigger change in the share price to be lucrative. On the upside, the maximum profit is theoretically infinite, while the maximum loss is restricted at $7.

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A “short straddle” is a technique for selling volatility or profiting from declining or constant volatility. It entails selling both a call and a put option with the same strike price. If the price is range-bound, the technique becomes lucrative. If oil is trading at $75 and the at-the-money strike price call option is trading at $3 and the at-the-money strike price put option is trading at $4, the strategy becomes profitable if the price of oil moves no more than $7. As a result, whether the oil price increases to $82 or falls to $68 (without brokerage fees), the approach is profitable. This technique may also be implemented using out-of-the-money options, known as a “short strangle,” which reduces the highest achievable profit while increasing the range within which the approach is lucrative. On the upside, the maximum profit is restricted to $7, but the greatest loss is potentially infinite.

The techniques described above are bidirectional, meaning they are unaffected by the direction of movement. If the trader has an opinion on the price of oil, he or she may use spreads to benefit while limiting risk.

Bullish and Bearish Strategies

The bear call spread is a common bearish technique that involves selling an out-of-the-money option and purchasing an even more out-of-the-money call. The difference between the premiums represents the net credit amount and the strategy’s maximum profit. The difference between the strike prices and the net credit amount is the maximum loss.

For example, if oil is priced at $75 and call options with strike prices of $80 and $85 are trading at $2.5 and $0.5, respectively, the maximum profit is the net credit, or $2 ($2.5 – $0.5), while the maximum loss is $3 ($5 – $2). This method may also be used with put options by selling an out-of-the-money put and purchasing an even more out-of-the-money put.

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The bull call spread is a similar bullish strategy that consists of purchasing an out-of-the-money call and selling an even more out-of-the-money call. The difference between the premiums is the net debit amount and represents the strategy’s maximum loss. The difference between the strike prices and the net debit amount is the maximum profit. For example, if oil is priced at $75 and call options with strike prices of $80 and $85 are trading at $2.5 and $0.5, respectively, the maximum loss is the net debit, or $2 ($2.5 – $0.5), while the maximum profit is $3 ($5 – $2). This approach may also be used with put options by purchasing an out-of-the-money put and selling an even more out-of-the-money put.

Futures may also be used to take unidirectional or complicated spread positions. The sole downside is that the margin necessary to establish a futures position is greater than that required to enter an options position.

The Bottom Line

Traders may benefit from oil price volatility in the same way that they might profit from stock price movements. This profit is made by employing derivatives to get leveraged exposure to the underlying asset without owning or having to own the asset itself.

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