Oil Stock Vol. It’s a Trap! – $COP

by CC December 10, 2014 2:35 pm • Commentary

Dan pointed me to this video from last night’s Fast Money with a very good discussion on oil related stocks:


I wanted to zoom in on one point made by Pete towards the end of the video related to playing high implied volatility (IV) in options in these names.  I actually mentioned this point in yesterday’s FCX post but I wanted to go a little more in depth on this one.

Ask an options market maker which sector of stocks that they’ve been burned most on selling “high” vol in and you’re likely to hear biotech. It’s pretty obvious why that is. The way pricing biotech options works is that you are basically a sitting duck. The stocks and the vol do nothing for long periods of time and then vol goes up four fold into some binary drug approval or possible takeover. Whatever you raise the IV to in the options is probably not enough. How do you price an option in a 30 dollar stock which can go to 60 or 5 based on a press release? It’s possible, but the price discovery of the order flow and the lack of liquidity in the options and the stock generally means that you’ll have already sold too much vol by the time you arrive at the correct level. In my years as an option market maker I rarely made money in biotechs and the only one that sticks out to me is when someone inexplicably sold me a bunch of calls for 1/8 (old timey fractions!) and then had to sell them back to me at $10 after the stock doubled overnight after some product approval. That’s literally the only one I remember. The rest were me getting picked off.

Which brings me to commodity related stocks. I would put these as second behind biotech stocks as the sector that is most difficult to make money selling “high” vol. The reason that is is that they are also stocks that chug along doing nothing and acting like boring industrial stocks until something happens in their respective commodity and all hell breaks lose in the stock. We’re seeing that right now in miners and anything oil production related.

On Fast Money the Discussion was about Conoco Phillips so let’s look at those options. Recently they’ve launched from a very low implied vol of around 20 to almost 40:

Screen Shot 2014-12-10 at 12.14.11 PM
1 year COP IV30 vs HV30 from LiveVol Pro

So is vol “high?” Maybe, maybe not. You’ll notice on the chart above the blue line representing the realized vol (blue line) in the stock is basically in line with what the options are pricing. That means the stock is moving around in a way that even at 40 vol, the options are only “fair.”

If COP was to bottom soon with oil then that vol would be a good sale but only if you could manage the deltas. Let’s say you sell a straddle or a strangle to take advantage of the high vol. You could get your vol collapse but it may come at the point to the stock having a V bottom and being 10 dollars higher from where you initiated. That’s a tough way to make money. And if you simply bought stock and sold an upside call , what call would that be (the Jan 70s at .70?) and is it really offering you any protection if the stock breaks down from here?

And here’s the main point summed up visually. Here’s the COP vol chart going back to 2008:

COP 7yr chart IV from Bloomberg

40 vol doesn’t look so cheap on that chart. The reason is that when oil goes crazy, these stocks go from industrials to dotcoms vol wise.

I love selling high vol as much as the next guy (probably alot more than the next guy!) but I have not had alot of luck doing so in this type of name. You almost have to wait for the complete reversal in the underlying commodity and chase vol lower after things return to normal and everything is all clear in oil rather than trying to sell into vol strength.