Excell with Options: Trading Energy options during historic volatility
It has been three months since we last looked at the energy space in Excell with Options. Suffice to say that a myriad of catalysts has hit the energy market from geopolitical risks in Europe, to environmental risks globally, to weakening economies and potentially falling demand in Asia. Energy prices are top-of-mind for all governments, and we are seeing U.S. and Europe taking action to combat the higher prices. When I have not looked at the market in some time, the first step for me is to typically look at the CME Group Volatility Index (CVOL). When looking at the CVOL, most volatilities are in the upper half of the range over the past three months.
Figure 1: Three month Energy CVOL
Furthermore, if we look on a year-to-date basis, we can see that we are at the upper end of the range for Nat Gas and for Energy overall. Implied volatilities remain firm in these markets as the level of uncertainty on a forward-looking basis has not diminished with many of the catalysts still solidly in play.
Figure 2: Year to Date Energy CVOL
With implied volatilities elevated, we need to be sharper than normal on our directional analysis because we will either pay more insurance premium if we choose to buy options or we will be looking to sell options, and short gamma can be difficult to trade in uncertain markets. To help me understand the lay of the investment landscape, I look to the Commitment of Traders (COT) Report to understand how various players are positioned in the market. In any trade there are two sets of fundamentals – the fundamentals of the underlying market and the fundamentals of the contract itself. Positioning can help us understand the latter because it may help us determine the reaction to news more so than determining what the news itself might be.
The first chart that catches my attention is the COT for crude oil. The chart shows that the length in the futures among the managed money community has been coming down steadily since the highs in the first quarter, but traders remain net-long though the positioning is dominated by spread activity. I am struck that the managed futures community is still net-long, even if less so, in a market that has been trading poorly for the last six months.
Figure 3: Commitment of Traders Report for WTI Crude Oil
My own thoughts on the fundamentals of the underlying market itself begins with an assessment of the supply and demand for crude oil products. I begin by looking at the U.S. Department of Energy EIA data. From this data, I can look at supply and demand and plot the difference in white below. I have drawn two horizontal lines showing whenever the supply and demand gets out of balance by 2% or more based on EIA data. The oil market is always closely in balance, and therefore, a difference of 2% of excess demand or supply can really begin to tilt prices. We can see on this 10-year chart that because of the U.S. fraction revolution in the 2014 to 2016 period, when there was less discipline on supply as independent companies were quickly bringing product to market, we tipped into an excess of supply of more than 2%. This had a negative impact on prices that lasted the entire period I have encircled while the excess supply lasted. Again, we see a supply and demand imbalance around Covid-19 with plummeting demand coupled with over supply. Once more, prices were under pressure until supply and demand got back within the 2% threshold. For all of 2021 and into early 2022, there was an excess of demand relative to supply and this led to rising prices throughout last year and into early this year, which were then only exacerbated by the geopolitical events in Europe.