Oil prices have been in the spotlight as the Syrian chemical
weapons crisis became front and center in the media. As the
political process has unfolded, price volatility in oil futures in
both directions has been extreme. Oil prices have traded in a wide
range the past two weeks between $104 - $112 per barrel.
As a professional option trader, I wanted to look at what the
implied volatility within options on oil futures was saying about
future oil prices. The oil futures option chain would give me some
possible clues about near and intermediate term price direction.
As an options trader, I am constantly focused on implied
volatility. I regularly look for stocks or futures that are showing
implied volatility levels that are higher than their historical
average. The very first thing I look at is the implied volatility
skew across multiple option chains with different expiration dates.
As such, when I looked at the oil futures option chains, I noticed
that the longer dated expirations had a slightly higher than normal
It is normal for the longer dated expirations to have higher
volatility levels, but what was striking to me was the implied
volatility in December was not much higher in the December oil
futures options than what it is in the front month expiration. I
found this odd so I looked at the spot oil futures prices going out
in time. The following chart comes directly from
As can be seen, as you move out further in time the oil futures
prices decline. This is a condition in the oil futures market known
as backwardation. According to Goldman Sachs in an article posted
"This rise in backwardation in oil, in our view, is not driven by
the events in Syria, but rather by increasingly tighter
fundamentals that are a result of the production shortfalls in
Libya and Iraq against improving Chinese demand."
Essentially Goldman Sachs' analysts go on to say that they believe
oil prices will see modest declines over the next 12 months, but
the backwardation will likely lead to returns being mostly flat
over the next year.
The fundamental backdrop according to Goldman Sachs appears to be
bullish in the short-term based on supply data. Unfortunately
fundamentals usually explain why an underlying asset moved the way
it did after the fact. Making money in the short term as a trader
is difficult when basing entry and exit decisions solely on
With the fundamental backdrop explained, I thought it would make
sense to look at key technical levels in the oil futures price
chart. The chart below illustrates key price levels based on recent
price action in oil.
Obviously the consolidation zone is setting up for a large move in
oil prices. The more important question to answer is which
direction will oil prices move? Will we see activity or supply data
that pushes prices above the resistance zone? Under that scenario,
the next logical price target for oil would be between $121 - $130
Should prices reverse course and break below support we should see
strong buyers come in around the $90 - $95 per barrel price zone.
At this point, the next stage in my analysis is going to be
probability based support and resistance for oil futures.
This process has to do with calculations involving implied
volatility to derive a probability based on price action today.
Clearly those probabilities change constantly, but the probability
data set is accurate in real time or at the time of entry.
Traditionally I will use standard deviations to help determine
price ranges as well as setting up trades that are directional such
as credit or debit spreads. Other times I will use standard
deviations to place credit spreads like Iron condors which focus
more on the passage of time and are generally more agnostic to
One standard deviation is typically calculated as 68%. Based on the
options on oil futures which expire in 36 days on October 18, a one
standard deviation move would place oil prices around $103 per
barrel to the downside. A one standard deviation move to the upside
based on Wednesday's closing prices would put oil prices around
$110 per barrel.
Interestingly enough, the price range expectations for a one
standard deviation move from prices on 09/11 at the close fits
precisely into the price range discussed above using technical
Varying data lining up like this does not always happen this
precisely, however when key price levels line up in this manner it
should not be ignored. The option data is basically indicating that
there is a better than 68% probability that in 35 days the price of
oil will be in the $103 - $110 per barrel price range.
The oil futures price chart shown below illustrates a two standard
deviation move. The lines drawn on the chart below demonstrate the
next key price levels should a 2 standard deviation move occur from
the current price at the October option expiration.
It is important to understand that there is roughly a 10%
probability that oil will even touch either key price level shown
above before the October 18 expiration. So what do all of these
probability calculations tell us?
Right now the implied volatility in the options that expire on
October 18, 2013 based on current oil futures spot prices has a low
probability of seeing a surge higher or a major move lower. The
option data essentially concurs with Goldman Sachs fundamental view
that oil prices are likely to stay in a trading range and
probabilities do not favor a big unexpected move.
I would point out, however, that the probabilities for a big move
are not 0%. There is a 1 in 10 chance that we see a big surge or
breakdown in price. As far as I am concerned, this is the option
markets calculated odds on any major escalation taking place in
Syria or the Middle East prior to October 18, 2013.
I think in the short-term we could see oil futures prices move up
toward $115 / barrel. However, the probabilities simply do not
favor a prolonged move above that level. Furthermore, it seems
likely that when the Syrian debacle concludes that prices will be
more likely to be in the $103 - $110 price range in roughly one
Instead of reading articles written by pundits who are making price
projections based on an educated guess, why not let the options
market be a guide for where the marketplace is pricing in the next
move? The analysts that are calling for a monster move in oil in
the near term have roughly a 10% probability of being right. I will
let readers decide whether a pundit or the option pricing in oil
futures is likely to be more accurate.
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