Jared Woodard of Condor Options explains why the threat of airstrikes against Iran is causing overall option prices on the United States Oil Fund (USO) to move higher.

Is Iran driving option prices higher? In short, probably. First, some context. Here’s the one-month volatility risk premium in United States Oil Fund (USO) options since 2007:

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Think of this as an estimate of how richly or cheaply priced options on crude oil are, relative to the actual historical volatility of the asset. Any ratio above 1.00 indicates that option buyers were willing to pay a premium above the value of the volatility subsequently exhibited by crude oil futures. As you can see, the ratio is usually greater than one.

When oil prices dropped precipitously in 2008 and oil volatility exploded higher, option buyers made out quite well (the ratio dipped towards 0.75); otherwise, it has generally paid to be a net seller.  Notice that the 50-period moving average of this ratio has been above 1.50 since December, which means that oil option premiums have been very rich compared to the volatility of the underlying.

Something is definitely keeping a permanent bid under options on crude—that’s not in doubt. The presumed cause is the threat of airstrikes against Iran. The chart below compares the value of the AIRSTRIKE.IRAN.DEC12 contract on Intrade against the relevant snippet of the USO 1M no-lag volatility risk premium (VRP)*.

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Since the start of 2012, it looks like there has been a reasonably tight relationship between the sentiment of crude options markets and that of Intrade participants. The run-up in USO VRP during late January and February coincides with an increase in the price of the airstrike contract.

While the Intrade probability is still hovering at 40% at the time of writing, crude options have already begun to discount the likelihood of this event (or of whatever was causing such elevated premiums).

Given the tiny volume in the Intrade contract (the largest daily volume was 87, while the size of the USO options market average daily volume is 88k contracts), and we can also include NYMEX WTI options as the IV of both products is in sync, we can assume that options markets are more efficient. The fact that the VRP was also high in November and December while the Intrade contract was not is curious, since there was some volume in the latter at that time.

Lots of things influence the prices of options on oil. There are all the standard supply and demand factors, plus other special items like whether the government will tap the strategic petroleum reserves (SPR). And, I’m as wary as anyone about drawing conclusions based on inactive Intrade contracts, but the correlation so far this year is interesting.

*There’s an important difference in the volatility estimates of the two charts. The top chart shows an estimate of the premium paid at time t1 for an option expiring at t30 over the annualized volatility that occurred in the underlying during t1- t30. As such, it’s a fairly accurate estimate of whether a given option is richly priced or not. The bottom “no-lag” version shows the ratio of implied volatility at t1 to the historical volatility that occurred over the previous month, i.e. t30- t1. This “live” version of the VRP is meaningful because it shows the amount of premium option buyers are willing to pay today without the benefit of foresight.

By Jared Woodard of CondorOptions.com

Disclosure: We have positions open in USO and oil (CL) futures options in the paid newsletter and in managed accounts.