In our last free commodity trading webinar we looked at a geared risk reversal with short calls in oil. This blog post will go through this trading strategy in detail.
With the recent moves in crude oil we are looking to put on an upside trading strategy that would allow us to capture a good portion of the upcoming move. Oil currently has a higher volatility of around 30%. Its usual volatility is around the 20% to 24% range so this means that any trade that can take advantage of this higher volatility could potentially be profitable.
Here is a graph of the current volatility in Sep Oil. Note the elevated levels:
If we were to place a traditional risk reversal in crude oil this would not give us any real exposure to volatility since the sold volatility in the short puts would be offset by the bought volatility of the long call.
However if we could create a position that overall made us net short options then we would indeed be short vega which is a desirable position considering the 30% volatility currently.
The trading strategy therefore a geared risk reversal which is a short put versus two long calls with two further short calls sold over the top of those. Another way to look at the strategy would be a two lot call spread versus put.
Constructing the trading strategy this way means that we have upside of 300 points times two on-call side. This is equal to $6000 and the position is juiced by the fact that we are short one put.
Because this structure is long only two options and short three it is net short vega and is long theta, in layman’s terms this means it is short volatility and long time decay.
Below is a diagram of the position:
If we take each of these Greeks individually and examine them it will give us a better idea of how strategy will perform. Firstly because we are short more options than we are long we are short vega. This means that any reversion to the mean in oil volatility i.e. coming down from its elevated 30% volatility toward its more traditional 20% to 24% range will mean the position realizes a gain.
From the time decay (theta) perspective because the option position is short more options than it is long it will collect time decay on daily basis. On top of this the fact that the option strategy has a lot of delta due to the extra sold puts means the position can be put on more profitably the lower oil goes. In this example you can see we have used the 53, 59 and 62 strikes and this gives the overall position a delta of around 60.
If we can put the position on lower (around 5450) not only do we get on a position that could potentially make $6000 at 62 it would also mean that we can collect a credit of around $1700 per lot. Should oil not move higher and just trade sideways or indeed even in a range between 53 and $59 the whole position will dropout worthless yet we would still receive the full credit of $1700 netting a healthy profit.
This is reflected in the P&L diagram below. Please note the dotted line is the expiry day line, and the other lines reflect the day to day P&L curve:
The only risk on the position is below the $53 mark. This is because that is where our short put is. We have received $1.70 for the position that means that the break even on the trade is at 5130, below 5130 we would have used all the credit received and will be into our own capital. We do not see oil going as low as 5130 as we are looking for target of $62 or possibly higher.
Therefore because this position will benefit greatly from a rise in oil or even make money should oil simply go sideways it is a very attractive position in the current climate. This is largely due to the time decay and volatility aspects of the trade as discussed above.
On any move below $53 we would monitor the position carefully and if we do not see a bounce coming then we would look to either closeout, hedge off or possibly roll out the put side depending on volatility into the next month and to a much lower strike.
As you can see this is not a conventional options position as it has two lots of calls for only one put. This trade is an excellent example of how you can use a custom-built option strategy to reflect a very specific view in an underlying instrument. As discussed above this trade reflects a bullish view but is also looking for a fall in volatility and to benefit from the passage of time, so there are multi dimensional aspects to the trade.
As well as placing more conventional option strategies at Paragon options we also regularly employ more custom-built bespoke options such as the one shown here. On top of this many of our trades are managed through to expiry through the use of advanced management of option greeks.
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15th Aug 2019