Since its peak in June 2013, the price of a barrel of oil has dropped nearly 60% to under $50, and there seems no end in sight. Supply continues to exceed demand – and that is within a decent economic growth pattern. Some believe that growth could be slowing sharply in the year ahead, which would sap demand for crude even more. Yet, more supply comes online each day as the producers see little reason to cut back on production. The imbalance continues, but at some point we will reach an equilibrium.
We could point to any number of reasons for why crude has fallen to these low levels, but the increase in crude volatility certainly tells the story. Below is the chart of the OVX, or the oil volatility index. I have been talking about this chart for nearly a month, when its second breakout occurred past 40. What a beautiful trend – it’s a mirror image of the crude chart. (Buying volatility on crude is not easily done; in fact, it really is not practical.)
A breakout past 57 clears the path for higher crude volatility; the trend line is coming in around the 42 level and rising sharply each day. Hence, a test back down would not be a surprise (it would signal a rise in crude). In fact, the move in oil is off the charts and has stretched well beyond the moving averages.
The best way to get long on crude volatility is to buy some short- or medium-term puts on a vehicle such as USO or other long crude instruments. This approach defines your risk and gives you some exposure to play the downside (or just protect some long positions).
From the CBOE:
The CBOE Crude Oil ETF Volatility Index (“Oil VIX”, Ticker – OVX) measures the market’s expectation of 30-day volatility of crude oil prices by applying the VIX® methodology to United States Oil Fund, LP (Ticker – USO) options spanning a wide range of strike prices.
The United States Oil Fund is an exchange-traded security designed to track changes in crude oil prices. By holding near-term futures contracts and cash, the performance of the Fund is intended to reflect, as closely as possible, the spot price of West Texas Intermediate light, sweet crude oil, less USO expenses.