The recent volatility in oil prices presents an excellent opportunity for traders to make a profit if they are able to predict the right direction. Volatility is measured as the expected change in the price of an instrument in either direction. If the current volatility is more than the historical volatility , traders expect higher volatility in prices going forward.
If the current volatility is lower than the long-term average, traders expect lower volatility in prices going forward. Volatility's Impact On Market Returns. Traders can benefit from volatile oil prices by using derivative strategies.
These mostly consist of simultaneously buying and selling options and taking positions in futures contracts on the exchanges offering crude oil derivative products. A strategy employed by traders to buy volatility, or profit from an increase in volatility, is called a " long straddle. The strategy becomes profitable if there is a sizeable move in either the upward or downward direction. For more, see What Determines Oil Prices? It is also possible to implement this strategy using out-of-the-money options , also called a long strangle, which reduces the upfront premium costs but would require a larger movement in the share price for the strategy to be profitable.
How To Buy Oil Options. The strategy to sell volatility, or to benefit from a decreasing or stable volatility, is called a " short straddle. The strategy becomes profitable if the price is range bound. It is also possible to implement this strategy using out-of-the-money options, called a "short strangle ," which decreases the maximum attainable profit but increases the range within which the strategy is profitable.
If the trader has a view on the price of oil, the trader can implement spreads that give the trader the chance to profit, and at the same time, limit the risk. The difference between the premiums is the net credit amount, and is the maximum profit for the strategy. The maximum loss is the difference between the difference between the strike prices and the net credit amount.
This strategy can also be implemented using put options by selling an out-of-the-money put and buying an even further out-of-the-money put. A similar bullish strategy is the bull call spread that consists of buying an out-of-the-money call and selling an even further out-of-the-money call.
The difference between the premiums is the net debit amount, and is the maximum loss for the strategy. The maximum profit is the difference between the difference between the strike prices and the net debit amount.
This strategy can also be implemented using put options by buying an out-of-the-money put and selling an even further out-of-the-money put. It is also possible to take unidirectional or complex spread positions using futures. The only disadvantage is that the margin required for entering into a futures position would be higher as compared to entering into an options position. Traders can profit from the volatility in oil prices just like they can profit from swings in stock prices.
This profit is achieved by using derivatives to gain a leveraged exposure to the underlying without currently owning or needing to own the underlying itself. Dictionary Term Of The Day. Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. A celebration of the most influential advisors and their contributions to critical conversations on finance.
Become a day trader. The Bottom Line Traders can profit from the volatility in oil prices just like they can profit from swings in stock prices. No thanks, I prefer not making money. Get Free Newsletters Newsletters.More...