J.W. Jones: Oil prices have been in the spotlight as the Syrian chemical weapons crisis became front and center in the media. As the political process has unfolded, price volatility in oil futures in both directions has been extreme. Oil prices have traded in a wide range the past two weeks between $104 – $112 dollars per barrel.
As a professional option trader, I wanted to look at what the implied volatility within options on oil futures was saying about future oil prices. The oil futures option chain would give me some possible clues about near and intermediate term price direction.
As an options trader, I am constantly focused on implied volatility. I regularly look for stocks or futures that are showing implied volatility levels which are higher than their historical average. The very first thing I look at is the implied volatility skew across multiple option chains with different expiration dates. As such, when I looked at the oil futures option chains I noticed that the longer dated expiration’s had a slightly higher than normal implied volatility.
It is normal for the longer dated expiration’s to have higher volatility levels, but what was striking to me was the implied volatility in December was not much higher in the December oil futures options than what it is in the front month expiration. I found this odd so I looked at the spot oil futures prices going out in time. The following chart comes directly from www.cmegroup.com.
As can be seen, as you move out further in time the oil futures prices decline. This is a condition in the oil futures market known as backwardation. According to Goldman Sachs in an article posted HERE:
“This rise in backwardation in oil, in our view, is not driven by the events in Syria, but rather by increasingly tighter fundamentals that are a result of the production shortfalls in Libya and Iraq against improving Chinese demand.”
Essentially Goldman Sachs’ analysts go on to say that they believe oil prices will see modest declines over the next 12 months, but the backwardation will likely lead to returns being mostly flat over the next year.
The fundamental backdrop according to Goldman Sachs appears to be bullish in the short-term based on supply data. Unfortunately fundamentals usually explain why an underlying asset moved the way it did after the fact. Making money in the short term as a trader is difficult when basing entry and exit decisions solely on fundamentals.