Oil Volatility and How to Profit From It

The recent volatility in oil prices presents an excellent opportunity for traders to make a profit if they are able to predict the right direction. Volatility is measured as the expected change in the price of an instrument in either direction. For example, if oil volatility is 15% and current oil prices are $100, it means that within the next year traders expect oil prices to change by 15% (either reach $85 or $115).

If the current volatility is more than the historical volatility, traders expect higher volatility in prices going forward. If the current volatility is lower than the long-term average, traders expect lower volatility in prices going forward. The CBOE’s (CBOE) OVX tracks the implied volatility of at-the-money strike prices for the U.S. Oil Fund Exchange traded fund (ETF). The ETF tracks the movement of WTI Crude Oil (WTI) by purchasing NYMEX crude oil futures. (For related insight, read more about volatility's impact on market returns.)

Traders can benefit from volatile oil prices by using derivative strategies. These mostly consist of simultaneously buying and selling options and taking positions in futures contracts on the exchanges offering crude oil derivative products. A strategy employed by traders to buy volatility, or profit from an increase in volatility, is called a "long straddle." It consists of buying a call and a put option at the same strike price. The strategy becomes profitable if there is a sizeable move in either the upward or downward direction. (For related insight, read more about what determines oil prices.)

For example, if oil is trading at US$75 and the at-the-money strike price call option is trading at $3, and the at-the-money strike price put option is trading at $4, the strategy becomes profitable for more than a $7 movement in the price of oil. So, if the oil price rises beyond $82 or drops beyond $68 (excluding brokerage charges), the strategy is profitable. It is also possible to implement this strategy using out-of-the-money options, also called a "long strangle," which reduces the upfront premium costs but would require a larger movement in the share price for the strategy to be profitable. The maximum profit is theoretically unlimited on the upside and the maximum loss is limited to $7. (For related insight, read more about how to buy oil options.)

The strategy to sell volatility, or to benefit from a decreasing or stable volatility, is called a "short straddle." It consists of selling a call and a put option at the same strike price. The strategy becomes profitable if the price is range bound. For example, if oil is trading at US$75 and the at-the-money strike price call option is trading at $3, and the at-the-money strike price put option is trading at $4, the strategy becomes profitable if there is no more than a $7 movement in the price of oil. So, if the oil price rises to $82 or drops to $68 (excluding brokerage charges), the strategy is profitable. It is also possible to implement this strategy using out-of-the-money options, called a "short strangle," which decreases the maximum attainable profit but increases the range within which the strategy is profitable. The maximum profit is limited to $7, while the maximum loss is theoretically unlimited on the upside. (For related insight, read about how low oil prices can go.)

The above strategies are bidirectional; they are independent of the direction of the move. If the trader has a view on the price of oil, the trader can implement spreads that give the trader the chance to profit, and at the same time, limit risk.

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

A similar bullish strategy is the bull-call spread, which consists of buying an out-of-the-money call and selling an even further out-of-the-money call. The difference between the premiums is the net debit amount and is the maximum loss for the strategy. The maximum profit is the difference between the difference between the strike prices and the net debit amount. For example, if oil is trading at $75, and the $80 and $85 strike-price call options are trading at $2.5 and $0.5, respectively, the maximum loss is the net debit, or $2 ($2.5 - $0.5), and the maximum profit is $3 ($5 - $2). This strategy can also be implemented using put options by buying an out-of-the-money put and selling an even further out-of-the-money put.

It is also possible to take unidirectional or complex spread positions using futures. The only disadvantage is that the margin required for entering into a futures position would be higher than it would be for entering into an options position.

Traders can profit from volatility in oil prices just like they can profit from swings in stock prices. This profit is achieved by using derivatives to gain a leveraged exposure to the underlying asset without currently owning or needing to own the asset itself.