Now, how do we propose to profit from all this wonderful information about this apparently neutral market? It looks like there’s little to choose between buying the market and selling it, but who says we must do either? Why not profit by writing an option whose striking price is most unlikely to be reached within a very limited time? Given that the HUQ options expire in five-plus weeks, on July 26, let’s just crunch a few numbers.
HUQ’s price tonight is 79.40. Seventeen per cent, just a trifle more than the maximum percentage upmove from June 17 to July 26 in our study, of 79.40 is 13.50, which added to 79.40 gives 92.90. We can reasonably assert that HUQ is historically unlikely to reach the 93.00 cent level. Is this analysis good enough? Should we therefore write the 93.00 HUQ calls? We could do so and have a fine expectation of earning a profit, but first we want to consider some other implications from our historical price study.
When did HUQ have its largest upmove in the period we’re examining?In 1999. What was happening in the energy markets in 1999? After years of bickering, back-stabbing, and cheating, and after the price of crude oil had collapsed in 1998, OPEC finally started getting its act together. It became, for the first time in a long while, a reasonably effective cartel. Crude and its products were wildly oversold throughout 1998, for one reason because various of the
OPEC players were fighting for market share to the detriment of prices. The major non-OPEC producer, Russia, was trying desperately to restore its financial credibility after its horrendous currency devaluation and bond default in 1998. Russia simply hadn’t the capital to invest in upgrading its oil industry’s infrastructure and increasing production of its staggeringly huge oil and natural gas reserves.The other 16+% rise in HUQ during our sample
period, in 1990, was of course due in large part to some market participants’ anticipation of Iraq’s reckless action on August 1, 1990, leading ultimately to the Gulf War. In theory,this sort of thing can recur at any time, but Iraq’s military posture offers no hint at the moment that they are preparing for a general mobilization,and certainly not in the next five weeks.It seems that neither of these sets of factors will affect the energy markets this summer.
HUQ, particularly, is nearer its yearly highs than its lows and isn’t oversold at all; some analysts even consider gasoline to be overbought at this time, and, if actually so, this factor would likely work to our advantage in writing call options. Gasoline supply is ample, considerably improved over the past three years. Capital, in limited but still significant amounts, is flowing back into the Russian oil industry, and the President is clearly making overtures to the Russians, presumably with a view toward establishing long-term supply agreements.
Even OPEC has finally seemed to realize that crude oil at $30.00/barrel when the world economy is relatively slow is not to their longer-term advantage.The practical implication of this supply change from 1999 for us traders is to allow us to be slightly bolder than we might otherwise be. Another way to say this is that the lack of evident threats to supply such as those that impelled large upward price moves in 1990 and 1999 lowers our potential event risk somewhat. We ordinarily prefer to select a striking price well past the extent of the largest historical price movement.
In this HUQ example, such a strike would be calculated as 13.50 (17% times tonight’s closing price) times 1.15, or 15.53, plus tonight’s price of 79.40, or 94.93. Achieving this price would require a 15% greater upmove than has ever occurred during the period.The 95.00-strike HUQ call would, by this process, be our candidate for writing tomorrow morning. Historically, and absent some off-the-wall event,we should bank a profit by writing this option some enormous percentage of the time, perhaps as often as 99 cases out of 100.
We might gain an additional perspective to aid in our selection of the strike of the call to write. Have another look at Table 6.1. Check the couple of years when HUQ prices were high at the start of our sample period. Interesting, no? If we accept this very limited set of data as indicative, upmoves in our named period are quite small when prices are high at the start of the period.
This is understandable. The dynamics of any market change along with its price. Cocoa prices don’t behave the same when the market is at $1700/tonne as when it’s $750/tonne. An $8.00/bushel soybean market behaves nothing like a $4.50/bushel market. And so with gasoline, too, no matter how much some academic types may yap about the price inelasticity of demand that is peculiar to gasoline.