Betting On Crude Oil, With Favorable Odds

12/09/08 08:54:04 AM

by Donald W. Pendergast, Jr.

On December 5, 2008, front-month crude oil closed below $41, the lowest price in nearly four and a half years. Does the bear market in oil have more downside, or is selling an out-of-the-money put a relatively safe bet?

Security: CL
Position: Accumulate

From its July high of $147.20 to today's intraday low of $40.81, crude oil has covered a lot of ground, and at a record pace. There have only been the most modest of corrective moves during the five-month selloff, making even experienced traders wonder if something in the way the world normally works has gone awry. Some might even argue that crude oil still has considerable downside, given the ever-worsening economic malaise that seems to be holding the entire globe in the iron grip of its unforgiving hand. Although fear and uncertainty are at heightened levels, the fact remains that when fear, despair, and disgust are widespread and at extreme levels, that's when various financial markets can sometimes stage unexpected turnarounds (although perhaps short-lived). We may be approaching a similar situation in the energy markets now that crude oil has shed 72% of its all-time high value in a mere five months. Here's a simple strategy that might be attractive to those who believe that crude oil has simply sold off too far, too fast.

FIGURE 1: CRUDE, DAILY. Slowing downside momentum, at least according to the detrend oscillator. Volatility is still extreme, creating high option premiums.

Graphic provided by: Ensign Windows.

The weekly crude oil chart says it all: It has been nothing short of the technical analysis equivalent of an avalanche. While various technical indicators have suggested that this market has been oversold for some time, the fact is that a market under extreme liquidation pressure can go oversold and then stay there for many months. Price does what it wants to do, and sometimes the best thing to do is just stand aside. Yet at the same time, it's difficult to imagine crude oil dropping another 40% or 45% in the next month or so.

And that is the premise of the trade setup I'm analyzing. As of December 5, 2008, a February 2009 $25 crude oil put option can be sold for about $400. With only 40 days until expiration (on January 14, 2009), February crude oil would have to drop 42% from today's close at $42.93 for such an option to close in-the-money at expiration. Crude oil volatility is still very high, and option premiums reflect that they are generously valued.

Here are some stats to consider if you're a hard-core crude oil bull interested in selling this out-of-the-money (OTM) deferred month put.

The option delta (measures the change in option price in relation to each full point value change in the underlying contract) is only -0.05 and the theta (daily time decay) is -0.11, meaning that the option will lose about $50 in value with a one-point gain in the price of crude oil, even as it sheds about $11 a day in time value with each passing day. Because this option is so far OTM, it will take a sharp, sustained move lower in the price of crude oil before the option doubles in price. For example, February crude would have to plunge from $42.93 to $34.93 in 15 days in order for the short put to double in price (where many conservative traders might consider covering at a loss, especially if they did not want to be assigned), even as it would have to fall to $32.65 in 30 days to double. One of the most attractive features of option selling strategies is the accelerated rate of time decay that occurs in the final 30 days before expiration. Assuming that the futures price ($42.93) and implied volatility (91.92%) remained unchanged, the $25 put option that was sold for $400 today would only be worth $290 in 10 days, $200 in 20 days, and $110 in 30 days. After 35 days, its value would shrink to $80. Time decay generally favors option sellers over option buyers, all else being equal. If implied volatility falls, that's also a major plus for a put seller, which is why you only want to sell options when implied volatility is at the high end of its two-year range and not at the low end.

FIGURE 2: CRUDE PROBABILITIES. With only 40 days til expiration, February 2009 $25 crude oil put has approximately a 4% probability of expiring in the money.

Graphic provided by: Option Wizard Online.

Options analysis programs are invaluable for this sort of numbers-crunching, and plugging the data into a probability calculator tells us that at today's implied option volatility (approximately 92% for the February 2009 $25 put), this short crude oil put has only about a 4% chance of expiring in the money. While anything can happen, even die-hard oil bears would likely agree that crude oil plunging an additional 42% in the next 40 days is improbable. Not that it's impossible, but it's an event that (for crude oil bulls, anyway) seems unlikely to occur. See Figure 2.

So perhaps we've uncovered two ways to play a short put sale in crude. The most conservative way is to sell the put, looking for the first opportunity to cover it (buy it back) at a reasonable profit, one that's commensurate with the risk. Many traders will cover a short put when they can buy it back for half of what they received when they opened the position. If crude keeps dropping, such short-term traders should consider covering if the option doubles in price. If you do not want to be assigned on a long crude oil contract at $25, this is probably the safest, lowest-risk way to play this opportunity. If, on the other hand, you actually wouldn't mind being long crude oil at $25, then you would simply sell the put and then mark off the days until option expiration on January 14, 2009. In this case, you'll either walk away with $400 in short put profits or be long one crude oil contract at $25, at a $400 discount.

You pick which game you want to play and then manage the final outcome according to your carefully considered trading plan.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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Betting On Crude Oil, With Favorable Odds

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