How to Profit From Oil Volatility

Oil volatility is about to spike.

Last Friday, oil surged 4.5% after Baker Hughes announced for the 25th straight week a drop in U.S. oil rig count.

Despite the price spike, oil-related stocks failed to follow suit, which was surprising since these securities have become extremely sensitive to short-term swings in the price of oil. Instead, oil stocks, for the most part, finished the day flat.

That’s because traders have their eye on the Organization of the Petroleum Exporting Countries (OPEC) meeting this Friday.

The group is not expected to make any policy changes. In fact, the 12-member committee will likely reiterate it’s willing to let prices fall to maintain market share, which in turn will keep pressure on lower oil prices.

This can make for a challenging environment to trade in, but there is one strategy that is poised to generate profits…

For long-term investors, your play is easy — go long.

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Years from now, $60 oil will be unheard of and we will be back to discussing whether $100 or $150 is the new floor for oil. But, in the short term, I expect oil will see more volatility.

With that said, I have a perfect way to play it. It’s with a rather simple options strategy on an offshore oil service company — SeaDrill (NYSE: SDRL).

The Breakout

Before I get into the instructions for the trade, I want to explain why it’s the ideal time to play SeaDrill.

So, let’s start with a chart.

Chart of oil stock SeaDrill

See larger image

Since the sharp drop in oil prices that pulled all oil-related companies sharply lower, SeaDrill has succeeded in finding support in December and in January around the $9 level.

But what I want to draw your attention to is the black lines I have added to the chart.

For the stock to be in an actual recovery, we would expect to see it make higher highs and higher lows. In the chart depicted above, SeaDrill has made higher highs, but it has also made lower lows. With increasing volatility in the price of crude oil combined with the stock’s technical patterns, we find SeaDrill poised to breakout in one direction or the other, but the problem is predicting the direction.

That’s why I want us to use a strategy that is called a straddle. This option trade essentially benefits from a stock moving up or down. You only lose money if the stock goes nowhere.

Here are the nuts and bolts of the trade.

Straddle the Fence to Win

Essentially, you are purchasing a call option and a put option at the same strike and expecting a major move. Just be sure to purchase equal amounts of call and put options.

For SeaDrill, I would grab the September 18, 2015 $12-strike put and call option for less than $3.50. At last glance, these two options combined would cost about $3.05.

My upside price target for the stock to rally to is $16.20, or $4.20 above the current price. This would represent a 37% gain in our options. On the downside, I am looking for a decline to $8.45. This would represent a 14% gain. Again, these are initial targets and based on our return at the date of expiration. But, the sooner we hit those price targets, the higher your gains would stand to be as you’re able to close out the option position before time decay has eaten heavily into the value of your options.

The beauty of this trade is that you don’t have to be right about the direction over the next three months. For our trade to be positive before expiration, we need the stock to make a new three-month high or low — either way we will be in the green.

Even though long term I am bullish on oil stocks, in the short term, volatility is going to continue to be the trade to make and trading a straddle is a great way to take advantage of that volatility.

Regards,
Chad Shoop Sovereign Investor
Chad Shoop
Editor, Pure Income