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.