Is Crude Oil Breaking Out?

| About: The United (USO)
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With turmoil continuing in the Middle East and the US economic recovery showing signs of life, crude oil has broken out to new 2-year highs. The risk premium built in from the Egyptian situation is obvious, as crude is up almost 8% from Thursday's close to yesterday's open ().

As can be seen, crude has rallied strongly above the 50-day moving average on high volume, a bullish sign that this upward trend will continue. However, many fundamental factors are also combining to give this rally in crude oil legs. Since so much of the world's oil supply passes through the Suez Canal, the longer there is unrest and uncertainty regarding the government in Egpyt, the longer crude oil will remain elevated. Adding fuel to the fire is that US and Chinese manufacturing data are coming in better than expected. The final piece of the puzzle is that US employment data remains soft, and the Fed has continually reiterated their intentions to keep interest rates at rock-bottom levels for an extended period.

The increased uncertainty regarding the situation in the Middle East has also caused crude oil options to spike in value. The below chart () shows the Oil Volatility Index, a measure of how expensive crude oil futures options are.

The crude VIX has broken out to levels not seen since the summer, and has done so in spectacular fashion. As we have commented in the past, breakouts of this nature in implied volatility are almost always contrarian indicators.

We implemented a very similar strategy on S&P 500 put options last summer to the great benefit of our clients. This was one of the main drivers of our 67% return in 2010.

Volatility on crude oil options will not be able to sustain this elevated level. Given the strong fundamental drivers and current high implied volatility, we recommend selling crude oil put options for March and April expiration. The 80.5 April put option for .55, meaning the trader collects $550 per contract as long as crude oil is above 80.5 on March 17. In order to hedge, trader can sell one crude oil futures contract for every put option they sell if crude passes below 80.5.

Also, we do not recommend pursuing this strategy on the USO. USO is a fundamentally flawed security that should never be traded by retail investors. Over the long run, it has shown that it does not keep pace with crude oil futures due to the negative roll yield problem. Because USO holds crude oil futures and not actual barrels of crude oil, it must sell the futures contracts it holds each month and buy the next month's expiration. Crafty hedge fund types can game this roll, and consequently sell the front month and buy the 2nd month in anticipation of this huge transaction. The amount that these traders make is the amount retail investors lose on USO.

Disclosure: We are long crude oil futures and short crude oil put options.