Oil traders are pricing a spike about the same as a crash.
Go 42 days out on the oil futures options, with crude around $87 a barrel, and look at the implied volatility, the number that sets the price tag on an option. The higher it is, the more the option costs.
A put, which pays off if oil falls, $10 below the market at the $77 strike has an implied volatility of about 47%. A call, which pays off if oil rises, $10 above the market sits at about 47% or 48%.
In other words, a bet on a $10 drop and a bet on a $10 jump cost about the same. The gap between those 2 numbers is called skew, and it tells you how much extra traders will pay to protect themselves from a move in one direction.
When traders are scared of something, they pay up for it, and the skew shows it. With everything going on in the world, you’d think they’d still be paying up for an oil spike, the way they were a while back.
That flat skew is a tell. Nobody’s paying for upside risk in oil, and when nobody’s paying for something, it gets cheap.
One way to take a shot at it is USO, the United States Oil Fund.
Go about 45 days out and price a $5-wide call spread, which means you buy one call and sell another call $5 higher to cut the cost. Right now, that spread runs about $1.48.
You risk $148 per spread to make as much as $500 minus what you paid, about $352, or roughly 2.4 times what you’re risking.
To be clear, this is the kind of trade where you take a little bit of a flyer, a small bet where the pricing is working in your favor. If oil goes nowhere or keeps sliding, you lose the $148, and that’s the most you can lose.
And I want oil to drop another buck before I put it on.
USO doesn’t track oil dollar for dollar, which confuses the hell out of people. And if you trade oil options on the futures directly, be careful, because those contracts are freaking huge.
Next time you pull up an option chain, check the skew before you check the price. It’ll tell you what the market’s afraid of, and what it’s ignoring.
Reading what’s going on under the surface of the options market is exactly what Brandon Chapman does. He spent 13 years at TD Ameritrade, and every morning he does it on one screen in about 6 minutes before the open.
$2,000 in cash goes to one person on Brandon’s live call tomorrow at 1 p.m. Eastern. It’s free, and you have to be there live to win.
Save My Seat For The Switchboard
To your success,
Don Kaufman
