Wednesday, September 30, 2009

Oil Double Play

Looks like we're going to have to settle for a double play on oil instead of the originally intended triple play. I rather inconveniently deleted Options Action off of my DVR and seem to have lost my sticky note that held the second trade's details. Although I remember it was a naked put sell plus a bear call spread, I don't recall which strikes were used.

Ah well....

How bout that IVolatility play on the USO? From a fundamental standpoint IVol asserted that due to seasonal factors, crude usually peaks around this time of year. From a technical view, USO recently broke it's up trend line on higher volume. So both forms of analysis allude to more bearishness to come.
[Source: EduTrader]

The suggested combo strategy was a bear call spread plus a put ratio backspread.

Call Spread:
Short Oct 35 call for $1.02
Long Oct 38 Call for $.30
Net Credit = $.72

This is a straightforward call spread where we're betting USO remains below $35.

Put Ratio Backspread:
Sell Nov 34 Put for $2.45
Buy (2) Nov 31 Puts for $2.40
Net Credit = $.05

Since most readers are probably familiar with the risk graph of a call spread, I'll simply display the risk graph of the backspread-
[Source: EduTrader]

Whereas the call spread merely needs USO to remain below 35 by Oct expiration, this backspread profits if USO drops significantly before Nov expiration. While the call spread is a less aggressive, higher probability bearish bet; the backspread is a more aggressive, lower probability bet. Although IVol suggested doing both, you could obviously choose to enter only one of the strategies if you prefer. In addition to the aggressiveness of both plays, another noteworthy difference is the fact that the ratio backspread is a negative theta trade. As such, I wouldn't recommend holding it all the way to expiration.

Of the plays highlighted, I think I still prefer the Nov 33-31 1x2 put spread mentioned in Monday's post.


semuren said...

Greetings Tyler:

I enjoy your blog. Thanks for taking the time to do it.

So I was in that 35/38 USO short call vertical and got stopped out by the Sep 30 6% jump in oil.

USO (and the futures) have come back up and kissed the back of the trendline and are now breaking down again. So I am considering re-entry.

I still like the trade for the same reasons: break of the trendline on oil, seasonality, contango working against USO. The one worry is the the futures are about the 200 day EMA on a year daily. And just above there is just where they bounced last week.

This time I would maybe sell the 36/38 for about 70-75. I would stop out at a close and subsequent open above the downward sloping trendline drawn from the high of AUG 25 to the high of SEP 18. That is now about 37.10.

I guess I am a little reluctant to re-enter because of the trauma last week with rip up. But when I think about that trade I realize that my mistake was not to defend by buying USO as it ripped up (always easier in hindsight).

You would have been fine in the ratio put spread trade, but I do not like to sell naked premium. Plus some of my trades are in IRAs where the margin treatment of naked puts is very bad.

So, I wonder (1) what do you think about the idea of re-entering and the set-up I propose? (2) If it were to start going against me again do you have any ideas about rules for defending with the underlying? So, at what point should I buy USO? How much should I buy? Just flatten the delta? And when should I sell out of it?

Any comments would be appreciated.

Tyler Craig said...


Thanks for the kind words. Glad you're enjoying the content I put out.

The first question I have for you is why you're choosing a $2 spread. Why not a $4 or $5 spread (36-40 or 36-41). Second, why use the 36 strike? Why not use 38 or 39 as the short strike? I certainly think a 36-38 call spread is a viable option if you really are bearish, but I want to make sure YOU have sound rationale for why you picked a $2 spread using 36 as your short strike.

I usually refrain from giving specific trade advice, so I'm going to have to plead the fifth on your first question. Remember, my personal preference and risk tolerance is completely different from anyone else. For call spreads, I tend to go a little further OTM, so if a stock was around $36, I'd consider using at least 37 or 38 as my short strike.

(2) I've done a few posts on managing call spreads that go awry. The first post was on April 13th, title "Roll Ups". The second one was on July 28th titled "Rolling with my Homies". In addition you could also use the labels on the left hand side of the blog and review the "bear call spread" archived posts.

If you are comfortable or adept enough to delta hedge if USO rises too much, that is certainly a viable option. Keep in mind when your delta hedging you have to babysit the position more than normal. There isn't one right way to do it, so it's up to you on how many shares you buy (whether you do a complete or partial hedge). I usually use a break of resistance as my trigger to start hedging.

semuren said...

Greetings Tyler:

Thanks for the reply. I looked at your posts on rolling bear call spreads. Even though I closed out re-entering would really be equivalent to rolling here.

BTW, as I am sure you have now noticed oil ripped up again today. So I am less inclined to be bearish on oil and most likely will not take this trade.

Good points about the strikes and pricing. I am just used to two point wide strikes in ETFs. I suppose I am using two point strikes to save a bit on commissions as really one point strikes seem better to me. The reason being that the hedge is going follow the short more closely.

Actually, I started also looking at the 37/39. I wanted to use the 36 because it was the closest OTM strike. Using a higher strike makes some sense but since this is a directional trade, I think it might be a good idea to just be out if it goes against me. Having my short at a higher strike might make me more inclined to hold. I think putting the short strike higher makes it a less directional, and thus different sort of, trade

Tyler Craig said...


I'm in agreement that $2 spreads certainly save commission vs. $1 spreads, particularly when you're putting in a decent chunk of change. I typically go wider ($4 or $5 spreads) for the same reason.