Crude Oil Prices at a Crossroads?
Today's Idea
With heightened volatility seen in the Crude Oil markets, option prices have become rather expensive. This increases the allure for short option sellers, but the potential for a large price move may make selling naked options outright too risky for many traders. One strategy that incorporates both buying and selling options is the ratio spread. Here a trader buys a closer to the money option and then sells 2 or more farther out of the money options to help pay for the option purchased. Ideally, one would like to do this trade for a credit, which would expand the profitable range of prices at which the futures could trade and have the option position turn a profit. With May Crude Oil trading at 105.36 as of this writing, a May Crude Oil 115 call could be bought and 2 May Crude Oil 125 calls sold for a credit of about 0.21, or $210 per spread, not including commissions. The trade would be profitable at expiration in April should May Crude Oil futures be trading below 135.00, assuming the trade is done at a credit close to the amount in this example. Given the risks involved in this trade, traders should have an exit strategy in place should the position move against them. An example of one such strategy would be to buy back the ratio spread before expiration should the May futures close above the strike price of the options sold.
Fundamentals
Who would have thought that Crude Oil prices would be capable of falling over $100 per barrel from its highs, and then rebound over 60% from the recessionary lows in just over 3 years? That is exactly what has occurred, however, as front month Oil futures are now trading firmly above the $100 per barrel mark, as the political instability that has arisen in North Africa and the Middle East has put a "risk premium"on Oil prices. Currently the biggest concern is the situation in Libya, where violence between supporters of Libyan leader Muammar Qaddafi and opposition forces have curtailed Oil production from this OPEC member. Though it appears that the Crude output lost from Libya is being made up from other OPEC nations who have spare capacity, primarily Saudi Arabia, the grade of Crude Oil is not as high as that from Libya. Ironically, the rising price of Oil comes at a time when the world's largest Oil consumer, the U.S., is experiencing an Oil glut. This is especially true at the delivery point for the NYMEX WTI contract in Cushing Oklahoma, where Oil in storage is at a record level. However, since Oil is truly a global commodity, any distortions in one area will not be enough to keep Oil prices in check, especially as we are seeing some improved economic data out of the U.S. and parts of Europe. Two major questions remain: First, will the political protests spread to the big gun of OPEC-- Saudi Arabia? Secondly, will the U.S. and European economies be able to handle $100 plus Oil prices in the longer term, or will high Oil prices put the brakes on the economic recovery?
Technical Notes
Looking at the daily continuation chart for Crude Oil futures since the record highs were made back in 2008, we notice that the recent rally has sent prices to the 61.8% Fibonacci retracement from the all time-highs to the 2009 lows. This area is seen by many technicians as a significant retracement level, which if violated may portend a potential test of the all-time highs! However, should this key resistance level hold, a pull-back to the 50% retracement near the 90.00 area would not be a surprise. The 14-day RSI has moved sharply into overbought territory, with a current reading of 77.67. The next major chart resistance level above the current price is not found until the 110.50 area, with minor support seen at 100.00 and chart support all the way back towards the 93.00 area.
Mike Zarembski, Senior Commodity Analyst
