Oil Optionality

By Larry Shover
Published January 09, 2015

It should come as no surprise that energy-related option volatility is elevated and, rightly so, as we find ourselves in the midst of a crude oil correction, which the market hasn’t witnessed in quite a while.  In the last two generations we’ve observed five or so crude declines of 35% or more and drawing definitive conclusions on its ultimate economic impact is precisely why we are witnessing such high and sustained levels of volatility.  

Markets bask in reason and normalization – until we have such expect the energy complex to continue moving within a very broad and volatile trading range.

Option term-structure measures the difference in implied volatilities for a particular underlying and strike across different maturities.  Other words, complicated (i.e. imperfect) mathematics computes a “fair-value” for an at-the-money call strike with 30 days till expiry and compares that to the same call strike with 60 days till expiry.  With troves of historical data, a trader can reason that the absolute (implied volatility) difference in maturity (i.e. “term-structure”) to be steep, flat, or inverted.

Conventional market environments are generally accompanied by an upward sloping “term-structure”.  This is due to the natural uncertainty associated with longer time horizons. For example: Personal disability insurance will cost a certain amount for a five-year term compared to the annual premium of a 15-year term as insurance underwriters possess a better sense of the odds of you becoming disabled over a 5-year term as compared to a 15-year term.  That being said, a “normal market” term-structure for an underlying could appear similarly to: March’15 (20.0%), June’15 (21.0%), September’15 (21.7%), December’15 (22.2%).

“Flat”, “Steep”, and “Inverted” Term Structures

A “flat” or “flattening” term-structure is where the absolute volatility difference between months becomes less.  Using the example above, the current volatility difference between March’15 and June’15 is 1%.  If that 1% differential moved closer to 0, traders would be quick to recognize that the term is “flattening”.  A “flat” term-structure generally indicates investor complacency – investors are not willing to pay an extra volatility premium for extra time.

A “steep” or “steepening” term-structure is where the market senses less volatility in the short-term compared to steadily increasing volatility in the medium or long-term.  We finished 2014 with interest rate and FX option products “steepening” given the myriad of upcoming events beginning January 19th, 2015 including: BOJ meeting,  a slew of Chinese data, and the ECB meeting.  Traders were far more willing to pay additional volatility premium for February 2015 options compared to December 2014 options as they wanted optionality to defend against the upcoming onslaught of economic events and December 2014 options would expire well beforehand – offering no protection.

An “inverted” term-structure is different than the “flat” or “steep” in that the volatility curve is downward sloping.  An “inverted” term-structure suggests a particularly bad present-day market environment, to the extent that the implied volatility (not the absolute price) for the short-dated options are priced higher compared to the medium or longer-dated options.  Energy Select SPDR Fund (XLE) is a perfect example whereas term-structure is “inverted” – quite inverted actually – as the market is hugely uncomfortable with the current oil environment and its eventual impact on the future growth and earnings of energy stocks.
Trading an Inverted-Term Structure

If you believe that oil prices will soon normalize and that the oil majors could potentially bounce back unscathed – or, even better than current consensus believes – you could express that conviction by buying an out-of-the-money call calendar spread.  This options strategy has limited risk (i.e. the premium you pay for the spread), a lot of upside potential and, importantly, takes advantage of the “inverted” term-structure mentioned.


XLE (reference: $76) I would suggest purchasing the June’15 $84 call while simultaneously selling the February’15 $84 call for a net purchase price of $1.75.  One purchased call calendar would cost $1.75 or $175 per 100 shares of XLE.

Critical Caveats

• In the next 161 days, you will need XLE to rally to $85.75 to break-even ($84.00 strike price + $1.75 premium paid).  This would be 11.37% higher than current XLE price of $76.00.

• However, because you sold (short) a February $84.00 call, you would want XLE to rally beyond the $84.00 strike AFTER your short February $84.00 call expires.

• Worst case scenario #1: If XLE expires above $84.00 at February expiration, you will be ASSIGNED (you will be short stock) XLE stock.  This will leave you with a resultant position of short XLE stock against long June calls.  Not the worst position in the world (you would be hedged) however, it defeats the purpose of the calendar spread!

• Worst case scenario #2: You hold your position to expiration in June and XLE remains below your break-even price of $85.75.  You will lose your entire $1.75.

• Best case scenario #1 – XLE rallies well beyond $85.75 by June expiration.  You are naked long the June $84.00 call and would profit 1:1 with the up-move.

• Best case scenario #2 – XLE doesn’t rally as planned however, the oil market normalizes and term-structure goes from “inverted” (presently) to more “normal” (upward sloping).  This would provide you with a potential profit opportunity as your short February $85.00 call would theoretically drop faster in value as compared to your long June $84.00 call.