Monday, February 1, 2010

Rolling with Crude Oil

The recent multi-week selloff in equities has certainly not been an isolated event. We’ve also seen commodities taking it on the chin as well. Whether you want to blame the bearish move in crude oil on the resurgent dollar or as a sympathetic move to equities, the fact remains that oil has retraced approximately 50% of its run from the July lows of $58 to the January highs of $84. Today’s charts spotlight fibonnaci retracements on both a daily and weekly time frame of Light Sweet Crude Oil futures (click image to enlarge).

Crude oil Daily

Crude Oil Weekly

[Source: EduTrader]

For traders still maintaining a neutral to bullish outlook on oil, this weekly pullback certainly seems like a potential “buy the dip” opportunity. Those believing that the recent weakness in equities and commodities is just the tip of the iceberg may want to sit this one out.

When playing crude oil, my current instrument of choice is the United States Oil Fund (USO) due in part to the heavy liquidity in its options. The bid-ask spread on these options often trade penny wide making them quite efficient trading vehicles. Any trader who has had bullish plays on USO coming into this last selloff is no doubt taking some heat. As for myself I’ve had to shake and bake on a few naked February puts that have gotten a bit under water. One lesson I’d like to highlight that has been re-iterated to me over the last few weeks is the futility of holding short puts when they move too far ITM. So, let’s walk through a naked put play from an intrinsic/extrinsic value perspective. For simplicity purposes, I’ll refer to intrisic value as IV and extrinsic value as EV.

Suppose when USO was at $39.50, we sold a February 38 put option for $1.00 ($1 EV, $0 IV). As soon as USO drops below $38, the 38 puts begin to accrue intrinsic value. Let’s say USO later drops to $37 and the 38 put option is worth $2.00 ($1 EV, $1 IV). Currently USO is worth $36.17 and the 38 put option is worth $2.15 ($.15, $2 IV). Notice how as the put has moved deeper ITM, it has incrementally lost it’s EV while gaining IV.

What’s the point?

Most traders enter naked puts for the sole purpose of profiting from time decay. If you allow your short put to move too far ITM such that it loses most or all of its extrinsic value, you don’t stand to gain anything from time decay. Even if the stock moves sideways, the deep ITM won’t lose any of its value. In fact, the only way you would profit from that point forward is if the stock rises in value. So, what adjustment would I make if my short puts moved too far ITM?

Roll Down-

Close the short USO 38 Feb puts and sell a lower strike put that resides less ITM or perhaps even OTM. This puts you in a better position if the stock remains neutral throughout the duration of the trade as these options have more extrinsic value to lose compare to the 38’s.

Want more? Check out these related posts:
Rolling with My Homies
USO Posts
Naked Put Posts

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