The Vagaries of Option Vega

The trouble in Libya is one of those external market shocks that take everyone by surprise. Gaddafi has been in power since he seized it in a 1969 coup. His rule has been similar to most autocrats, full of hero worship and enmity. The important thing is that his country has been relatively stable for quite a long time. Therefore, the largest oil reserves in Africa and the 9th largest oil reserves in the world have never been questioned. Additionally, Iran is using the chaos across north Africa to assert their power as a dominant force in the area by sending naval vessels through the Suez Canal for the first time since 1979 in a direct affront to Israel and a test of Egypt’s new military led leadership.

Markets don’t like the unknown. Every market has a built in fear bias. The fear bias can be measured through the use of options. Fear is reflected in stock index put options. There is always more fear that the market will go down, rather than up. This is why put options in the stock market are always more expensive than call options. Fear in the crude oil market, just like the grain markets, is based on delivery concerns. Therefore, call options typically carry a premium over the put options. Tuesday’s market action illustrates the, “mania” that accompanies outside market shocks and the impact of the unknown.

The breakdown of order in the markets can be seen in the large moves in the option markets. Traders turn to the option markets to buy insurance in times of panic and that is when the built in biases of fear premiums really shows up. There is one option trading term that needs to be understood. Vega measures how sensitive an option is to volatility. The higher the degree of volatility, the more expensive the option becomes. Theoretically, volatility premium would be reflected somewhat equally based on the unknown market direction. The market is going to move big, we just don’t know which way.

Fear premium can be illustrated using vega. April crude oil traded more than $10 higher before closing at $95.42, $5.70 higher (6.4%) for the day on Tuesday. Mathematically, we would expect an April option to move proportionately. Tuesday’s vega calculation for the options at the opening price was .098. A one percent move in price for a barrel of crude oil means the price of that option would increase or decline by .098 cents. Therefore, Tuesday morning, the price of the April crude 90.00 put should have declined by .098 for every percent the crude oil market rallied. Conversely, the April crude oil 90.00 call should have gained .098 for every percent the crude oil market climbed.

The actual option prices reflect the emotional distortion of the marketplace. The April crude oil 90.00 put option saw its price decline from $2.85 to $1.02  while the April crude oil 90.00 call saw its value appreciate more than 300%, climbing from $2.55 to $10.65. The fear of the unknown combined with built in market bias can be a tremendous tool for leveraging the limited risk of option ownership. The buyer of the 90.00 call option on Tuesday morning would have spent $2,550 for the right to own 42,000 gallons of light sweet crude oil for April delivery and by Tuesday afternoon, it would have been worth $10,650.

The crude oil market is precariously poised for a major jump should the political climate of North Africa persist. Commercial traders in this market had positioned themselves for $90 being the top. Should these players be wrong it would add considerable fuel to this rally as they are forced to buy back the future production that they’ve already hedged.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Crack Spread and High Gas Prices

The price of gasoline is holding above $3.00 per gallon and bouncing its way higher. This is happening even though the price of crude oil remains fairly well capped technically at $90 per barrel in spite of the Egyptian conflict and concern over control of the Suez canal. The price of crude oil is also showing fundamental weakness at these levels. The weekly commitment of traders report shows a record net short position by commercial traders who are expecting the market to decline from these prices. Furthermore, the gap in prices between current crude oil and crude for future delivery continues to widen. This is called, “contango.” The wider the spread becomes, the more economic incentive there is to sit on and store the oil. In the face of bearish fundamentals, why is the price of gasoline so stubbornly high?

I believe that gasoline demand as a finished product will outpace demand for raw crude over the coming months. A barrel of crude oil equals 42 U.S. gallons.  The refined barrel produces 2/3 gasoline and 1/3 heating oil depending on the quality of the crude oil input. The difference in price between the combined value of the heating oil and unleaded gasoline produced versus the crude oil input is called the, “crack spread.”

The first part of the answer to our question lies in the global dynamics of this spread. Refineries are currently making about $17.20 per barrel that they refine. This is significantly higher than the $6.50 or, so they averaged throughout 2010.  This added profit margin should incentivize greater refinery capacity utilization. This is where the first disconnect becomes clear. Refineries in the U.S. are only operating at 85% of capacity. Our main foreign suppliers are operating at lower levels than that. China, however, ran at record levels of refinery operation throughout 2010.

The Chinese position demands recognition. China sold approximately 18 million cars in 2010 while the U.S. sold just over 12 million. More importantly, the China Association of Auto Manufacturers claims that 2010’s sales pushed Chinese vehicle ownership up to about 6% of the total Chinese population. By contrast there are approximately 80 cars for every 100 Americans. China’s crude oil imports for January have increased by 33% over last year’s and their 2011 projection is for 5.27 million barrels per day. The Chinese are building a wealth of strategic reserves. It won’t take long for them to compete head to head on the open market for the 8.9 million barrels per day the United States currently consumes.

The second primary contributor to stubbornly high domestic gas prices is the mandatory edition of ethanol to the fuel we use. The government mandate is to increase the ethanol per gallon of fuel to 11% from 8.5% for 2011. U.S. ethanol production is uncompetitive because it is based on corn. Sugar based ethanol, like Brazil’s is more efficiently produced. The government’s energy plan currently imposes a $.54 per gallon tariff on imports while subsidizing the creation of ethanol plants and the corn that goes into them. Gas prices topped $4 per gallon in 2008 and  corn is 20% higher now than it was at this time in 2008.

Asian refineries continue to soak up the global supply of crude oil while our refineries enjoy the profits of the crack spread foreign demand is generating. We are sitting near the seasonal lows in petroleum products and the corn market has yet to build in weather related planting premium. Our low operating capacity combined with higher ethanol content and the rising price of corn could create quite a domestic price shock.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Long Only is Not Diversification

The cycle of bubbles will continue. Assets will always chase higher returns. The markets in the United States that are available for the general public to allocate funds to are mostly, “long only.” The general investing public is provided with a number of choices as to what they can buy to invest in. We’ve seen the cycle rotate from sector to sector within the stock market or, between stocks and bonds. Arts, antiques, cars and real estate have all had their periods when ownership was lucrative. Fortunately, being able to short sell commodities with a phone call or a mouse click is much easier than selling a car or a house when the market turns.

Lately, commodities have taken center stage as the thing to own. We’ve seen it in gold and oil and more recently in grains, agricultural commodities and stock index futures. Thirteen commodity futures markets set new records for commodity index funds’ open interest in 2010. Over the last few weeks, we’ve seen commodity positions being transferred from the index funds to the small speculators. This transfer of positions from index and commercial traders to small speculators typically occurs near the end of a protracted move.

Bubbles are created through the over popularity of an asset class. The speed of the bubble cycle increases when leverage is involved. We’ve seen this in the stock market crashes of 1929 and 1987 and as recently as May of 2010 in the, “Flash Crash.” The world is still unwinding the over leveraged global mortgage debacle. The new vogue in leveraged assets has been the creation of commodity funds. Commodity funds have provided a long only investment entry into the futures markets for the novice investor. These funds have gone from non-existent to more than $370 billion in equity at the top of the first commodity bubble in 2008. We have since surpassed that total.

The commodity index fund market is no different than the mortgage backed security market was when it was marketed to the public as a way to, “ratchet up returns while providing diversification.” Investment office salespeople need products to sell. These products are usually a good idea at the beginning but, become overpopulated and over valued as a result of a good idea turning into the next big thing and eventually falling of their own weight.

I’ve suggested that the global economy is due to slowdown. Furthermore, the governmental response to the economic crisis has done little to right the long-term path of our economy. Over the last three years, the stock market is higher, reported unemployment is below 10% and gas prices have stabilized. However, it has taken a Herculean effort by the government, which has dropped the Federal Funds rate from 4.5% to 0, expanded the Treasury’s balance sheet by $1.5 trillion and printed $1 trillion on top of that just to bring GDP and our population’s complacency back to where it was at the end of 2007. This is the Government’s form of a leveraged asset, which is also becoming overvalued and overpopulated and is in peril of falling of its own weight.

Diversification among long only assets will not provide the type protection people expect when these markets begin to falter. Over the last five years, there have been 13 weeks when the S&P 500 closed more than 5% lower from week to week. Conversely, there has only been one week in the last 5 years when bonds have closed that much higher. That was the flight to quality run of November 21, 2008. That was the height of the panic of the meltdown. The truth is, when liquidation hits the market, it tends to cross all classes. These are the days when the commentators lead in with, “There’s a lot of red on the board today.” Gold, copper, oil, grains, cattle, etc. have all averaged at least as many large losses as the stock market. Forty percent of these losses coincided with large stock market declines. In this day of instant everything, instant liquidation to cash is only a few mouse clicks away in the futures markets rather than end of day fund settlements.

The futures markets were meant to be traded from the long AND the short side. Commercial traders use this feature to manage their own production and consumption concerns. Individual traders can also have this direct link to the commodity markets. The liquid flexibility of the futures markets allows individual traders to hedge their holdings through the direct use of short selling just as it allows leveraging of outright exposure on the way up.  The right brokerage relationship can make them the perfect tool in the hands of the individual managing their own portfolio as opposed to the long only fund salesman seeking out the next tool in the general public.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.