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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%.

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.

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