Oil volatility and how to profit from it

If traders can predict the right direction, the recent fluctuations in oil prices provide them with an excellent opportunity to profit. Volatility is measured as the expected change in the price of an instrument in either direction. For example, if the oil volatility is 15% and the current oil price is $100, it means that traders expect oil prices to change by 15% next year (to $85 or $115).

If the current volatility is greater than the historical volatility, traders expect higher price volatility in the future. If the current volatility is lower than the long-term average, traders expect lower price volatility in the future. The Chicago Board Options Exchange (CBOE) Crude Oil ETF Volatility Index (OVX) tracks the implied volatility of the parity strike price of the American Petroleum Fund Exchange-traded funds.The ETF tracks the trend of WTI crude oil (WTI) by purchasing NYMEX crude oil futures.

Trading volatility

Traders can benefit from fluctuating oil prices by using derivatives strategies. These mainly include the simultaneous buying and selling of options and opening positions in futures contracts on exchanges that provide crude oil derivatives. The strategy that traders use to buy volatility or profit from increased volatility is called “long straddle”. It includes the purchase of call options and put options at the same strike price. If there is a considerable change in the upward or downward direction, the strategy will become profitable.

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For example, if the oil transaction price is $75, the parity strike price call option is traded at $3, and the parity strike price put option is traded at $4, then the profit of the strategy exceeds the change in the price of oil at $7. Therefore, if oil prices rise by more than US$82 or fall by more than US$68 (excluding brokerage fees), the strategy is profitable. You can also use out-of-the-money options (also known as “long-term strangulation”) to implement this strategy, which will reduce the upfront premium cost, but requires greater volatility in stock prices to make the strategy profitable. In theory, the maximum upward profit is unlimited, and the maximum loss is limited to $7.

Strategies that sell volatility or benefit from falling or stabilizing volatility are called “short strides.” It includes selling call options and put options at the same strike price. If the price fluctuates in a range, the strategy will become profitable. For example, if oil is traded at $75, parity strike price call options are traded at $3, and parity strike price put options are traded at $4, then if there is no more, the strategy will become profitable instead of oil prices. Change of $7. Therefore, if oil prices rise to US$82 or fall to US$68 (excluding brokerage fees), the strategy is profitable. It is also possible to implement this strategy using out-of-the-money options called “short strangulation”, which will reduce the maximum achievable profit, but will increase the profitability of the strategy. The maximum profit is limited to $7, and theoretically the maximum loss is unlimited on the upside.

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The above strategies are two-way: they have nothing to do with the direction of movement. If the trader has an opinion on the price of oil, the trader can implement a spread, giving the trader a chance to profit while limiting risk.

Bullish and bearish strategies

A popular put strategy is the bear market call option spread, which includes selling out-of-the-money call options and buying further out-of-the-money call options. The difference between the premiums is the net credit, which is the maximum profit of the strategy. The maximum loss is the difference between the strike price and the net credit amount. For example, if oil is traded at $75 and call options with strike prices of $80 and $85 are traded at $2.5 and $0.5, respectively, the maximum profit is the net credit, or $2 ($2.5-$0.5), The maximum loss is 3 USD (5 USD-2 USD). This strategy can also be implemented using put options by selling out-of-the-money put options and further buying out-of-the-money put options.

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A similar call strategy is the bull market call option spread, which involves buying an out-of-the-money call option and selling further out-of-the-money call options. The difference between the premiums is the net debit amount, which is the biggest loss of the strategy. The maximum profit is the difference between the strike price and the net debit amount. For example, if oil is traded at $75, and call options with strike prices of $80 and $85 are traded at $2.5 and $0.5, respectively, the maximum loss is the net debit, which is $2 ($2.5-$0.5), The maximum profit is 3 USD (5 USD-2 USD). This strategy can also be implemented using put options, that is, buying an out-of-the-money put option and selling further out-of-the-money put options.

You can also use futures for one-way or complex spread positions. The only disadvantage is that the margin required to enter a futures position will be higher than the margin required to enter an option position.

Bottom line

Traders can profit from fluctuations in oil prices, just as they can profit from fluctuations in stock prices. This kind of profit is achieved through the use of derivatives to obtain leveraged exposure to related assets, without the need to currently own or need to own the assets themselves.

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