How To Profit From A Broken Oil VIX

Includes: USO
by: Kent Moors

As we brace for another bout of volatility in crude oil prices, I've got some bad news: The main yardstick used by market makers to measure that volatility is no longer working. In fact, the oil market we're now facing is fundamentally different from the one we encountered even one year ago. And it requires a fundamentally different approach.

This "yardstick" I am talking about is something called the "Oil VIX" – short for the Crude Oil Volatility Index. As with other volatility indicators coming from the Chicago Board Options Exchange, the OVX measures implied volatility.

To accomplish this, it uses the United States Oil Fund LP (NYSEARCA:USO), an exchange-traded fund that tracks the futures contract prices for West Texas Intermediate, other oil products, and certain options based on those futures.

The OVX is neutral with regard to direction. Volatility, as we have certainly seen in the last several months, can intensify in prices moving higher or lower. OVX doesn't care which way things are moving; it simply gives us the apparent intensity of that move.

Now, this reflects boththe component absolutely essential in determining options prices, and the one element creating the greatest problem traders face – implied volatility.

As you might know, implied volatility is the major component in estimating options pricing – the necessary insurance policy for a trader in futures contracts. It is the most famous product of the most famous formula ever devised for setting the acceptable price of an option.

Nailing down the actual underlying volatility at any given moment in the market – or in this case, in a particular commodity – is like trying to capture lightning in a bottle. To make this workable, you must translate it into some figure than can be applied.

Much has been said lately about the family of VIX indices – the most widely used reflecting volatility in the S&P. In the last two cycles of intense market volatility, the talking heads on TV have been jabbering about the family of VIX figures, as the indices for the S&P, the Dow, and oil scroll across the screen at regular intervals.

The concept seems simple enough: An index such as the Oil VIX tells us how risky traders think the market actually is. A higher VIX figure should translate into a lower trading price (or lower S&P or Dow level, depending on the VIX considered). Higher risk, after all, should mean a lower market.

That still holds true for the broader market VIX figures, but no longer for oil. And that is the problem.

As volatility has increased, it is now not unusual to see the OVX andthe WTI price moving in the same direction. This is because all CBOE VIX figures (whether for oil or the S&P or whatever else) actually give us a 30-day moving average of the implied volatility. If the primary cycles of the volatility are occurring in ranges narrower than 30 days, OVX can actually be misleading in telling us either direction or intensity.

Sure, the figure itself will go up or down, and the commentators will speak solemnly about how significant being above a 40 or a 50 may be. Truth is, in such constricted movements, the figure is of little help at all.

And then there is another major distorting influence to contend with:

A "New Norm" for Oil

There are options now available to bet on which way OVX will move, and by what amount. In other words, OVX itself can be traded. What began as a yardstick, therefore, has become its own derivative.

Actually, since the OVX figure is itself a derivative – from the actual market trading – these OVX options are secondary derivatives. That makes the OVX less an indicator of genuine oil pricing and more an indicator of how traders are handicappingthe spread of pricing over time.

So long as the volatility is manageable, the problem can be tolerated. Unfortunately, that is no longer the case. And that brings me to the primary problem in all this: What we are experiencing in Oil VIX is not simply accelerating volatility. That is significant in itself, yet it can at least be shoehorned into the trading formula to make some sense.

The current development involves extreme short cycles of volatility followed by more traditional periods of change. More of the overall volatility is now found in short pulses, producing a concerted distortion. There is even a name for this. It is called kurtosis.

However, when the volatility is compressed into shorter cycles, it has a negative multiplying effect on the market's ability to compensate for the instability. Yikes -- welcome to the "new norm" for oil.

The key now is not to trade the OVX, but to position on the curve to maximize the profit potential.

Original post