We have had no shortage of questions recently on how to play the USO for a reversal in crude. I wanted to share a write up that I did for a friend who manages money for high net worth individuals who are asking the same, but considering different time frames to express a contrarian bullish view:
The United States Oil Fund (ticker: USO), an etf that tracks the price of WTI Crude Oil, has declined 45% over the past year and 25% over the last month alone. It is now down 10% ytd in 2015:
For those looking to express directional views with options on USO, it has become increasingly difficult as 30 day at the money Implied Volatility (the price of options) has risen almost 300% from the July lows:
To underscore the high price of options, with the USO at $18.28, the Jan 2016 (a year from now) 18 strike call is offered at $3.00, or nearly 17% of the underlying etf price. If you bought that you would need a move of at least $3 before Jan16 expiration to make money.
Which brings me to the attractiveness of selling puts at high implied volatility to finance the purchase of calls or call spreads. This trade structure is known as a risk reversal and takes advantage of high prices of downside puts, while also creating an asymmetric return profile, as the etf is unlikely to go to zero but on the flip side has the potential to rise more than 100%. The nature of commodities usually results in skew towards the calls because the risk more often is a spike in prices not a crash. But the speed of the recent downward move has meant that skew to the downside has steepened and put sales financing call purchases take advantage of that skew.
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Trades: I want to look at three durations for an oversold reversal to play out. The first is a very near term trade with defined risk, the second is one in July 2015 that catches the next scheduled OPEC meeting (in June) which could serve as a positive catalyst, and the third a Jan 2016 expiration, a full year from now:
April 2015:
USO ($18.28) Buy April 20/25 call spread for 80 cents
-Buy to open April 20 call for 1.00
-Sell to open April 25 call at 20 cents
Break-Even on April Expiration:
Profits above 20.80 (up 14%). A max potential gain of 4.20 at 25 or higher (up 36%).
Losses of 80 cents between $20 and $20.80 with a max loss of 80 cents at $20 or below
Rationale: At the money calls and call spreads appear fairly expensive. This trade structure goes out-of-the-money in search of somethin dollar cheap that offers a break-even at levels where the etf was trading just two weeks ago. It’s upside is capped at $25 which is shaping up to be formidable technical resistance.
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July 2016:
USO ($18.28) Buy July 15 / 22 risk reversal for ten cents
-Sell to open July 15 put at 90 cents
-Buy to open July 22 call for 1.00
Break-Even on July Expiration:
Profits above 22.10 are unlimited (up 21%.)
A loss of ten cents between 22 and 15 and put the stock below 15 (down 18%) with losses 1 for 1 with the stock below.
Rationale: This less risky play than buying the stock in a volatile situation where timing the exact bottom could be tricky. It plays for a sharp move to the upside where the worst case scenario is that you are put the stock down 18%, which would place the USO down about 70% from the 2014 high.
OR Closer to the Money Participation on the Upside:
USO ($18.28) Sell the July 15 Put to Buy July 20 / 24 call spread for even money
-Sell to open July 15 put at 90 cents
-Buy to open July 20 call for 1.50
-Sell to open July 24 call at 60 cents
Break-Even on July Expiration:
Profits of up to $4 between $20 and $24 with max gain of $4 above $24
Losses: worst case scenario, put the stock at 15 (down 18%) with losses 1 for 1 with the stock below that.
Rationale: This is a zero premium risk between $15 and $20 and plays for a sharp move to the upside where the worst case scenario is that you are put the stock down 18%. That would place the USO down about 70% from the 2014 high. Under this scenario you get profit participation more than 10% lower than the straight risk reversal, but you have given away upside above $24 (up 31% from current levels).
Alternatives: The strikes can obviously be moved around. For instance rather than buy the July 20/24 call spread, one could play for greater potential payout by moving up the strikes and widening them out, or selling one put and buying two calls (for instance sell one July 15 put at 90 cents and buy two July 25 calls for 45 cents each or 90 cents total.
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Jan 2016:
USO ($18.28) Buy Jan 2016 14 / 24 risk reversal for Even Money
-Sell to open Jan16 14 put at 1.00
-Buy to open Jan16 24 call for 1.00
Break-Even on Jan16 Expiration:
Profits above 24 are unlimited (up 31%.)
Losses below 14, down 23%, put the stock at 14 or below and lose 1 for 1 like stock.
Rationale: This is a zero premium way (between $14 and $24) to play for a sharp move to the upside where the worst case scenario is that you are put the stock down 23%, which would place the USO down about 75% from the 2014 high. The strikes are widened both on the put sale and the call purchase as this structure has an additional 6 months to play out as opposed to the July examples detailed above.
OR Closer to the Money Participation on the Upside:
USO ($18.28) Sell the Jan 2016 14 Put to Buy Jan 2016 20 / 24 call spread for even money
-Sell to open Jan’16 14 put at 1.oo
-Buy to open Jan’16 20 call for 2.00
-Sell to open Jan’16 24 call at 1.00
Break-Even on July Expiration:
Profits up to $4 between$ 20 and $24 with max gain of 4 above $24.
Losses: The worst case scenario is you are put the stock at 14 and lose 1 for 1 below that.
Rationale: This is a zero premium (between $14 and $20) way to play for a sharp move to the upside where the worst case scenario is that you are put the stock down 23%, which would place the USO down about 70% from the 2014 high. Under this scenario you get profit participation more than 10% lower than the straight risk reversal, but you have given away upside above $24 (up 31% from current levels).
Alternatives: The strikes can obviously be moved around. For instance rather than buy the Jan 20/24 call spread, one could play for greater potential payout by moving up the strikes and widening them out, or selling one put and buying two calls (for instance sell one Jan 14 put at 1.00 cents and buy two Jan 26 calls for 60 cents each or 1.20 cents total.
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It is my opinion that we are have not yet reached a bottom, and that we will likely see some sort of capitulation before it is all said and done, but I definitely understand the inclination to step in after such a steep decline. I would love to see total annihilation before putting one of these trades on but we often don’t get that chance.