Erratic Price Fluctuations in Crude Oil and Rising Options Volatility

Crude oil futures have traded between $102 and $109 per barrel within the last few weeks (7/19 to 8/9 2013), touching both extremes twice within that period of time. Thursday’s (8/8) 3-week low of 102.24 on the September futures contract was followed by a surge up to a 105.92 high late that day and into Friday, a 3.5% rebound.

As a direct result, crude options volatility for at-the-money options expiring in September, a measure of expected price swings in crude oil and a gauge of options value, also increased.

This market move is a great opportunity to discuss option volatility. Change in options volatility is an important component when calculating an option’s value and can shed light on possible options trading strategies to implement. When you look at option prices and consider certain strategies, knowing whether an option or set of options are “over priced” or “under priced” due to high or low options volatility affords useful information as to whether you should be selling options or buying them.

Knowing an option strategy’s volatility level and whether that level could increase or decrease once that strategy is implemented can be the difference in that strategy’s outcome. This is true for strategies as straightforward as buying calls and puts, as well as for complex, multi-legged options positions.

Further, measures in options volatility can act as “listening device” to anticipate changes in volatility of the underlying futures market. Even in an environment where the underlying futures market is trading relatively calmly, an increase in options volatility can serve as a warning sign of higher volatility in the underlying futures market. Although it will not provide insight into either its direction or trend, there are options strategies available that take a neutral position in the market and can profit from a significant move by the underlying futures contract – in either direction. The risk to a strategy of this type is if the underlying futures contract fails to make a significant enough move to affect a positive result for the strategy.

Increased volatility in the futures markets, the likes of which crude oil has exhibited in the last couple of weeks – trading up to 18-month highs, can push options volatility higher and deem worthy a look into the options strategies that can take advantage of it.

SPECIAL NOTE: Trading Futures, Options on Futures, and retail off-exchange foreign currency transactions involves substantial risk of loss and is not suitable for all investors. You should carefully consider whether trading is suitable for you in light of your circumstances, knowledge, and financial resources. You may lose all or more of your initial investment. Opinions, market data, and recommendations are subject to change at any time.