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Today


IVolatility Trading Digest™


Volume 8, Issue 40
Peak Oil

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
Please read IVolatility Trading Digest™ Disclaimer at the very bottom of this page

To add comments or to ask questions please click here (or use the blog "COMMENTS" link at the very bottom of the blog page).

Crude oil prices started their astonishing price rise in January of 2007 right on cue for a normal seasonal rise into the summer. By August prices were accelerating and continued higher going into the end of 2007. The usual seasonal year-end decline was hardly noticeable. As 2008 began crude prices seemed to be a one-direction trade as prices accelerated even faster. Something unusual was taking place in this market. OPEC and the Saudis claimed there was plenty of supply on the market but prices were being bid up regardless. Many analysts revived earlier predictions about peak oil and the impending decline in production as the justification for higher prices in anticipation of supply shortages in the future. Then in the middle of the summer the selling began. Was peak oil just a multi-billion dollar hoax?

We offer a few more comments about peak oil below but first our market review and an update of our short crude oil trade suggestion that began two weeks ago.

Market Review

S&P 500 Index (SPX) 940.55. For this past options expiration week the SPX gained 41.35 points in a somewhat less chaotic, but still very volatile trading. It is not surprising that major indexes would attempt to close higher for the week. Option volume was abnormally high last week and a good percentage of that volume was put buying which drove up the option implied volatility. From the perspective of a market maker when he sells a put, he looks to short the stock or ETF in order to remain delta neutral. On options expiration day, he would need to reverse this hedge and buy in his shorts for those positions that are out-of-the-money and about to expire, otherwise he would be net short on Monday morning, and this is a risk he would most likely want to avoid. We suspect there was considerable options expiration related short covering on Friday.

CBOE Volatility Index ( VIX) 70.33. After making another new all time intra-day high of 81.17 on Thursday October 16, 2008 the VIX closed out the week at 70.33 and still very high historically. In order to confirm higher equity prices we need to see the VIX starting to decline. Below is a chart showing the recent historical perspective.

Open 67.65, High 74.48, Low 62.44, Close 70.33, lower by 2.72 on the day.

US Dollar Index (DX) 82.41. The US Dollar strength continues as money continues to seek safety, especially in the US Treasury market where yields have been reduced to .78% for 13 week Treasury Bills. On Wednesday the yields were as low as .13%, so a somewhat higher yield is encouraging. 90-day Eurodollar deposits ended the week yielding 4.50% down from 5.25% last week, also encouraging.

TED Spread 3.63. The TED spread is difference between the 90-day LIBOR (London Inter-bank Offer Rate) and the equivalent term Treasury Bills. In normal market conditions this spread is about 50 to 75 basis points or .50% to .75%. Since the US Government guarantees Treasury Bills and Eurodollar deposits have bank risk the TED spread give us a way to measure the current perceived risk in the Eurodollar market. Here is the updated Bloomberg chart showing a decline for the week of 1.01 percentage points.

Open 4.08, High 4.08, Low 3.53, Close 3.63, -.45 on the day.

NYSE McClellan Summation Index. Last week our market breadth indicator continued downward declining another 176.95 points to –1,496.29. However, Thursday and Friday the numbers improved and were better balanced compared to earlier in the week. Since bear markets end when the Summation Index is below –1,200 we are looking for an inflection point and concave upward in the curve to confirm the change in direction of the NYSE Index.

Strategy

High market implied volatility provides opportunities to sell expensive options. Two basic strategies are to sell straddles and strangles or combinations that have similar characteristics. The current environment is problematic since we are most likely at the bottom of the market decline and there is a chance we could see a rapid move upward on short covering. In addition, for the next three weeks or so third quarter earnings are being announced and this can add to volatility. These developments would not help straddles or strangles. Unless the company has already announced earnings, as some have, we would suggest caution with respect to the use of straddles and strangles. Other ideas include buying stock and selling calls (covered calls) and selling expensive puts. Look for opportunities in stocks that you would be interesting in buying now that also have high-implied volatility. Ideally, you would want the sale of the call or put to reduce your cost basis to a point below the most recent pivot and the 52-week low for the stock.

Short Crude Oil Update

(USO) United States Oil (USO) 59.37. This ETF reflects the spot price of West Texas Intermediate (WTI) light, sweet crude oil. For the week it declined 7.13 while the prior week’s decline was 8.75. At the same time the Implied Volatility Index Mean increased 16.43 to 71.43 the first week and then declined 1.97 in the second week to 69.46.

For the original USO combination strategy suggestion see IVolatility Trading Digest™ Volume 8, Issue 38, Oktoberfest, dated October 6, 2008.

For last week’s update see IVolatility Trading Digest™ Volume 8, Issue 39, Wild Ride, dated October 13, 2008.

Since the bear call credit spread expired at the end of the week we are able to book the entire 1.875 credit from the original combination offsetting almost all of the debits from our other two put spreads.

From the soon to be released IVolatility.com Profit and Loss Calculator here is the current risk profile for the position.

Now since the rate of decline is slowing and the implied volatility has declined from the prior week we suggest closing the long put ratio backspread with the extra long put that has exposure to declining volatility while retaining the long Nov 60/55 bear put spread. At the middle prices between the bid and offer the backspread is priced at 6.20. Since our net debit in the position is .10 we book a gain of 6.10 or $610 assuming a one-lot position size.

SU: We want to protect our potential gain in the remaining bear put spread so we will set a stop/unwind on a USO close above 62. In the meanwhile if USO continues lower we still have a short position without further volatility risk.

In IVolatility Trading Digest™ Volume 8, Issue 25, Saudi Oil Summit, dated June 23, 2008 we wrote:

“A number of recent events suggest that there may be a coordinated effort underway to lower crude oil prices and the Saudi Summit may mark the beginning of more coordinated actions designed to curb prices.”

After the meeting we were surprised by the lack of coverage by the financial press. There were hardly any mentions of the event and no details were provided about any agreements that were made.

Crude Oil basis December 2008 (NYMEX) (CLZ8) 72.13.

Shortly after the Saudi Oil Summit crude oil peaked on July 11, 2008 at 148.60 per barrel. No doubt there are many factors contributing to the subsequent decline including the claim made by OPEC and the Saudis of excessive speculation in the futures market. If excessive speculation played a part in the price rise we would expect to see declining open interest in the futures market as long positions are liquidated. In November of last year, open interest was 1.6 million contracts, by the middle of May when crude prices were still rising it had declined to 1.5 million. At the price peak on July 11, 2008 the reading was 1.4 million and by this week they have declined to 1.1 million. So in the last 11 months open interest has declined about 31% with half of the decline in open interest occurring in the last 3 months since the peak in prices. We are seeing long liquidation in the futures market and with hedge funds under redemption pressure we think there could be more to come.

We are not claiming the entire price increase that began on January 15, 2007 at 57 and accelerated in August of ’07 from 67 was futures related. Nevertheless it must now be obvious to most everybody that it accounted for a substantial portion just as OPEC and the Saudis claimed throughout the entire episode.

Here is what the president of Saudi Aramco said last November as oil prices were accelerating.

"We have grossly underestimated mankind’s ability to find new reserves of petroleum, as well as our capacity to raise recovery rates and tap fields once thought inaccessible or impossible to produce.” Further he said, “we still have almost a century’s worth of oil under the conservative scenario…and nearly 200 years’ worth under the target scenario. As a result I do not believe the world has to worry about ‘peak oil’ for a very long time.” So said Abdallah S. Jum’ah, Saudi Aramco’s president and CEO, during his address at the 11th Congress of the World’s Energy Council in Rome last November.

Apparently nobody was listening to the Saudis, as everybody was focused on making the case for peak oil production as a justification for higher prices.

While we do not have the analytical resources of the Wall Street investment bank that first produced the $150 per barrel price forecast and then the $200 per barrel forecast we do think OPEC has regained credibility for knowing something about their market. Perhaps in the future we should be paying more attention to OPEC and less to Wall Street analysts. If so, then here is the current OPEC outlook.

"Even if governments are successful in calming equity markets and unfreezing credit markets in the near future, the fallout on the real economy from financial market headwinds is expected to be considerable."

The rapid crude oil price rise was like an alarm bell ringing and it was heard. In a democracy is seems we are only capable of focusing on the crisis of the moment. There is no doubt the credit market crisis needs attention, but hopefully the US will not allow this opportunity for greater energy independence to be lost even if crude oil prices continue to decline in the near term.

Previous Issues and Reader Response Request

All previous issues of the Digest can be found by using the small calendar at the top right of the first page of any Digest Issue. Click on any underlined date to see the selected issue. As usual we encourage you to let us know what you think about how we are doing and what you would like to see in future issues. Send us your questions or comments, or if you would like for us to take a look at a specific stock or ETF just let us know. Use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com Website.

Comments:

Really a good analysis

Posted by KS (143.166.226.63) on October 20, 2008 at 11:36 AM EDT

KS,

Thank you for that kind comment. We think crude oil will continue lower for awhile on hedge fund liquidation.

Jack

Posted by Jacktrader (68.109.71.202) on October 22, 2008 at 11:24 AM EDT


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IVolatility Trading DigestTM Disclaimer
IVolatility.com is not a registered investment adviser and does not offer personalized advice specific to the needs and risk profiles of its readers.Nothing contained in this letter constitutes a recommendation to buy or sell any security. Before entering a position check to see how prices compare to those used in the digest, as the prices are likely to change on the next trading day. Our personnel or independent contractors may own positions and/or trade in the securities mentioned. We are not compensated in any way for publishing information about companies in the digest. Make sure to due your fundamental and technical analysis homework along with a realistic evaluation of position size before considering a commitment.

Our purpose is to offer some ideas that will help you make money using IVolatility. We will also use some other tools that are easily available with an Internet connection. Not a lot of complicated math formulas but good trade management. In addition to Volatility we use fundamental and technical analysis tools to increase the probability of success and reduce risk. We prepare a written trade plan defining why the trade is being made, what we call the "DR" (determining rationale) and the Stop/unwind, called the "SU".