After presenting a trader friend with the potential edge in selling crude oil’s recent quinquennial highs, he responded, “Cool, but how high can it go?”
This question can plague many attempting to act on what the data tells them, and it’s especially justified for volatile commodity markets like oil and natural gas. Thankfully, crude oil has been around for a while, and there’s enough data to both display an opportunity and measure the risk around it.
Crude Oil: Trading the Reversal
Knowing that a market has historically reversed course from its highs can be great news for contrarians looking to sell expensive crude oil, and an average move lower of -$2.50 in the month following said high can pose a big fat edge.
|Next Day||Next Week||Next Month|
Source: Yahoo! Finance (https://finance.yahoo.com/) as of 10/13/21
Extending Duration in Crude Oil
The challenge becomes withstanding the P/L volatility that can come along with a short crude oil position, not to mention the market’s ability to reach $100 a few times in the last decade.
CL \ Crude Oil
The first step to extending duration is often to simply reduce size. Small Crude Oil (SMO) futures cut the size of traditional crude futures (CL) contracts tenfold. Next, offsetting part of the short position with a long deltas via a short put can help even further. Options on the highly correlated, similarly sized Energy Sector ETF (XLE) offer a solid spot to do so.
|-1 CL Future||-1 SMO Futures||-1 SMO Future
-1 30Δ XLE Put
Source: Data from Yahoo! Finance (https://finance.yahoo.com/) and dxFeed Index Services (https://indexit.dxfeed.com); theoretical values as of 10/13/21
Crude oil has a volatile reputation, and rightfully so! The commodity has both broken the $0 bound and bounced back above $80 since the start of 2020. But the modern trader has the tools to remain chill during periods of explosiveness in this market and potentially take advantage of the opportunity in front of them.
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