OPTIONS

Although crude oil prices have been holding pretty steady, even amidst negative cliff-related news in the media, oil options appear to be significantly overpriced, writes Jared Woodard of CondorOptions.com, and could set up a viable trade opportunity.

WTI crude oil options are priced at a substantial premium above the trailing volatility of the underlying. One-month options using the VIX methodology (OVX) were priced at the Friday close above 24%, while the one-month close-to-close historical volatility of USO was just 14%.

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Fig. 1. USO 1M volatility risk premium. Source: FRED, Condor Options
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The distribution of USO volatility risk premium has some fairly extreme values—look at the reading near 3 in late 2011—but the current value of 1.75 is in the top decile of observations since 2007. The obvious assumption is that options are significantly overpriced.

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Fig. 2. USO daily prices. Source: Yahoo!
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However, low historical volatility explains some of the premium. That is, with 1M HV also at extremes (<5% quantile), options markets are pricing in some reversion to the mean. USO has traded particularly quietly in the new year, with a 10-day HV of just 9.5%. If we assume that oil volatility trades more in line with historical averages, does the option premium look justified? The mean USO 1M HV since 2012 has been about 24%, right in line with current option values.

That doesn’t mean there isn’t a viable trade opportunity here, but it will require more work. If crude continues this quiet streak, we can expect implied volatility to come in, and delta-hedged straddles could perform well. On the other hand, the difference between OVX and USO 1M HV has averaged about 6 points, which means option implied volatility could just as easily march higher, point-for-point, if the underlying becomes more volatile. So although the time series of volatility risk premium suggests an easy trade setup, an intuitive look at the market reveals a more complicated situation.

By Jared Woodard of CondorOptions.com

Tickers Mentioned: OVX, USO, VIX

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