Thursday, February 10, 2011

An Oil Options Trade with High Precision This USO spread can be rolled for a continued payoff

Commodities markets recently have been manic with gyrations of the price of materials, metals, and energy. Given these wild fluctuations, let’s consider options trading in the United States Oil Fund (NYSE: USO) that indicates a solid probability of success.

I look at some trades this way: The development of precision high altitude bombing during World War II resulted in a dramatic reduction in casualties while inflicting devastating consequences on enemy forces. I view the sort of option strategy described below as the equivalent of high altitude precision bombing.

As is shown on the daily price chart below, there is substantial support in the region of $35.60 — $36 provided by a recent swing low and the 200-day moving average.

US Oil Fund

US Oil Fund 200-Day Moving Average

In selecting the structure of option trades, I usually like to consider the volatility environment in which we currently operate. This is important because of the tendency of implied volatility (IV) to revert to its mean. The knowledgeable trader factors this into his trades in order to put the wind at his back. Trades can be selected and constructed to benefit (positive vega trades) or suffer (negative vega trades) from increases in implied volatility. As you can see in the chart below, IV is currently in the lower quartile of its historic value for this specific underlying: (more)

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