Oil Volatility Could Be the Best Trade Right Now
Trading is often thought of as an exercise in forecasting the direction of the next major price move. That can be rewarding, both financially and mentally. At its core, trading is challenging from a psychological perspective and being right on the direction of the price move can improve confidence.
But, some traders focus more on volatility than direction. Their philosophy is that if prices are moving, they can be pursuing a profit and they are, with some strategies, agnostic as to the direction of the move.
This type of a strategy could be rewarding to investors in energy markets right now.
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A Perfect Storm for Energy Volatility
In the oil markets, a number of factors are pointing towards potentially higher prices. But, this is a market that can be notoriously difficult to forecast. At times like this, all that can be said with certainty is that volatility is likely to increase.
One factor is a May 12 deadline set by President Donald Trump to decide whether to continue waiving U.S. sanctions against Iran was also buffeting downward pressure on prices.
Iran’s foreign minister said U.S. demands to change its 2015 nuclear agreement with world powers were unacceptable as a deadline set by President Donald Trump for Europeans to “fix” the deal loomed.
Trump has all but decided to withdraw from the 2015 Iran nuclear accord by May 12, CNBC reports, though exactly how he will do so remains unclear.
Iran re-emerged as a major oil exporter in January 2016 when international sanctions against Tehran were suspended in return for curbs on Iran’s nuclear program.
The deadline looms as supply concerns mount.
North Sea oilfields connected to the Brent oil pipeline have stopped production due to a shutdown at the UK’s Sullom Voe oil terminal, the Brent pipeline operator said, reducing output of the crude.
Global oil supply has tightened with production cuts led by the Organization of the Petroleum Exporting Countries and its allies.
The latest Reuters survey showed OPEC pumped around 32 million barrels per day (bpd) in April, slightly below its target of 32.5 million bpd, due largely to plunging output in Venezuela.
Russia recently announced its own compliance with a global deal with OPEC and other producers to curb output stood at 95.2 percent in April, with its output unchanged at 10.97 million bpd.
“The price move today is probably based off Iran and the tight oil supply market that we already have,” said Rob Thummel, portfolio manager at energy investment manager Tortoise Capital in Leawood, Kansas.
“The margin for error right now is just so low in the oil market that you can’t just take supply off the market.”
The chart shows the trend in oil prices. Prices broke out of a multiyear trading range late last year and are now at levels that haven’t been seen in more than two years.
Traders should note that momentum indicates further gains are likely. The next chart adds the stochastic indicator, a measure of momentum.
The indicator shows there are more potential gains in the price as it is just breaking above 80, a level associated with price gains in the past.
Traders have a number of ways to trade oil but the easiest could be with exchange traded funds (ETFs) that track energy stocks. iShares US Energy ETF (NYSE: IYE) is a liquid ETF that has active options.
Volatility Seems Certain
When we expect volatility, but cannot forecast the direction of the price move, a long straddle can be used. This strategy is a combination of buying a call and buying a put, both with the same exercise price and expiration date.
Together, these two options contracts create a position that should profit if the stock makes a big move either up or down.
The strategy hopes to capture a quick increase in implied volatility or a big move in the underlying stock price during the life of the options. The risks are known when the trade is opened and the potential gains can be large. This is shown in the diagram below.
Source: The Options Industry Council
The maximum gain on a straddle is, in theory, is unlimited. The profit at the expiration date of the options will be the difference between the stock’s price and the strike price, less the premium paid for both options. There is no limit to profit potential on the upside, while the downside profit potential is limited only because the stock price cannot go below zero.
The maximum loss is limited to the amount of premiums paid to open the position. The worst that can happen for a trader with a straddle position is that the stock price holds steady. If the stock’s price on the expiration date is exactly equal to the exercise price of the options, the options expire worthless, and the entire premium paid to put on the position will be lost.
A Specific Trade in the IYE
To trade this idea, we could trade options on IYE.
The straddle can be opened using options expiring on May 18 with an exercise price of $41. The May 18 $41 call is trading at about $0.85. The May 18 $41 put is trading at about $0.30. The total cost to open the trade is about $1.15, before commissions which should be relatively small at a deep discount broker.
The total premiums add up to about 2.5% of the price of IYE. The question is whether or not a move of that size is likely within the next few weeks. Given the current state of the market, it seems safe to assume that a significant price move is likely. Whether that move is up or down, this trade could profit.
The long straddle is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide the potential for gains and defined risk that could be lower than owning the stock. This strategy should also have a high probability of success.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.