The Oil ETF’s Standard Deviation Skew: A Nerdy Thriller . . .

The past couple of blog posts I have written have been more expository than entertaining. Based on page views and reads, I have quickly realized that my writing style needs to change, and quickly. So here is my first attempt at being cheeky.

Unfortunately, my natural writing voice was lost in a series of research papers and expository essays about financial topics that no one in their right mind would ever care about. Looking back, basket weaving classes might have offered more substance, and certainly more utility.

Normally in this instance I envision Simon and Garfunkel’s famous “Sound of Silence” softly playing in the background as another one of my writing projects slowly fades back into the void of desolation. Before I completely fall to ruin, I am overcome with the pure joy of knowing I have few readers to lose, so what the heck . . . here goes.

Going forward, I will do everything in my power to try to make my writing entertaining, yet informational. Obviously rants are going to occur, but perhaps we will just allow that until my editor slams the hammer down on my head. You will know this has happened because I will not be allowed near the Wamhoff Financial social media platform anymore and I will return quickly to my four computer screens that fail miserably at providing any human interaction most days. Although emails are close . . . but alas, I digress.

Instead of boring you with very fact based and articulate data on oil as I promised to do, I am going to state unequivocally that no one has a freaking clue where oil prices are going. One expert says oil is going to $10 per barrel and the next one says it will be at $200 per barrel in two years. Bollocks! No one has any idea where oil prices are going to be in the future for sure.

A well placed missile in the Middle East or an outright war in the Ukraine potentially change everything. Guessing oil prices 6 months from now is a foolhardy endeavor and a complete waste of time, but some of my only “friends” do provide us with some clues.

Derivatives, one of my favorite analytical trading tools (and a great topic of discussion to make an unwanted date abandon you quickly) offer some forward looking observations based on implied volatility in crude oil futures options. Please do not worry about what any of that means, it is the only way to express that particular thought without spending 5 paragraphs explaining it while readership continues to falter.

Shown below is the current United States Oil ETF (Ticker: USO) October expiration options chain courtesy of TD Ameritrade at the close of business on March 18, 2015:
USO October_Pic 1

As can be seen above, I have highlighted the USO October 18.50 Calls and the USO October 13 Puts. The reason I have highlighted these contracts specifically is because they represent a one standard deviation (68.2689492) move in USO from the March 18, 2015 closing price projected out into the October monthly option expiration.

By reviewing the standard deviation skew, we can see what the options (derivatives) marketplace for USO is suggesting about USO stock prices out to the month of October of 2015. The USO ETF’s price is not perfectly congruent to the price structure of oil futures, but it is fairly close in terms of USO’s overall price iterations.

According to Yahoo! Finance, the closing price for USO on 03/18/2015 was $16.76 per share. Based on the implied volatility analysis provided by TD Ameritrade’s ThinkorSwim trading platform, it becomes quite clear that the options marketplace is pricing in an almost $3.76 per share potential downside move.

This is calculated by taking the closing price on 03/18/2015 and subtracting the one standard deviation move lower, which is the USO October 13 Put highlighted in the options chain shown above. Thus, 16.76 – 13 = 3.76, which represents a one standard deviation (68.27% Probability) move lower or a 22.43% move lower in the price of USO. Now a quick calculation is required to determine a one standard deviation move higher in the price of the United States Oil ETF (USO).

The upside move expected by the options marketplace one standard deviation higher would correspond closely with the USO October 18.50 Call. Based on the previously referenced USO closing price from Yahoo! Finance, this would correspond with a one standard deviation move that would see USO prices move roughly $1.74 per share higher. This one standard deviation move higher would represent a 10.38% positive move to the upside based on the Yahoo! Finance March 18, 2015 closing price for USO.
USO Closing_Pic 2
***USO Closing Price Data Provided by Yahoo! Finance***
***Standard Deviation & Implied Volatility Analysis Provided by TD Ameritrade’s ThinkorSwim Platform***

So what does this actually mean? The primary point is that based on the same unit of risk (1 standard deviation – 68.26), the USO October, 2015 monthly option expiration is pricing in a potential move that is more than two times more volatile on the downside versus the upside. The table shown above clearly illustrates the potential downside return on a one standard deviation move is -22.43% while a one standard deviation move to the upside is only 10.38% higher.

The differential in potential returns is known as standard deviation skew. Based on the above data, USO prices could have more than two times more volatility on the downside versus the upside based on market conditions as of the close of business on March 18, 2015.

It is important to understand that these data points change every day based on the USO stock price, implied volatility, and the passage of time (Option Greek: Theta), among several other nerdy factors.

However, the skew is quite clear that downside risk could be more severe as of the market close on March 18, 2015. This is critically important in shaping our views about future price action, but it is certainly not a guarantee or necessarily forward looking.

When financial pundits and economists discuss future oil prices, the easiest way to determine if they are practicing sheer foolishness, is to exam an option chain close to the time frame they are pontificating about. In this case, the probability that crude oil prices will reach as low as $10 per barrel (3.45% probability of touching that price) or as high as $200 per barrel (less than 3.45% probability of touching that price) are obviously infinitesimally small.

The data points listed above are factored based on the closing implied volatility levels and data reported by TD Ameritrade’s ThinkorSwim trading platform at the close of business on March 18, 2015.

Now that I have that dose of nerdy ecstasy out of my system, in my next article I am going to discuss the supply fundamentals that could be impacting oil prices related to storage capacity. This next article will be my last article on oil for a time.

My next journey may take us down a totally different path all together. Who knows, the first thing I have to do is improve my readership . . . . Until next time, Happy Investing!