Crude Oil is Primed for Gamma ScalpingCrude Oil price have remained sharply range bound for the last two months. CME Group’s West Texas Intermediate (WTI) futures have traded between USD 70-80 a barrel since early November last year. Sharply shifting supply and demand outlook explains range bound trading in crude oil.
In this paper, we discuss diverging factors affecting crude oil price and illustrate gamma scalping strategy to harness returns from range bound price moves. Gamma scalping is a well-established dynamic options strategy that enables investment returns from sharply oscillating price moves.
CRUDE OIL’S DIVERGING PRICE OUTLOOK
Tailwinds powering the oil prices increase is fuelled by (a) OPEC+ members decisions on deep supply cuts, and (b) geopolitical risks in the middle east remains elevated. On the day of the conflict escalation, crude prices spiked 2.6% higher.
Some of these attacks have affected crude oil tankers in the region risking supply disruptions.
Headwinds pressing oil prices down include record US crude oil production. The US churned 13.25 million bpd (barrels per day) of oil in Q3. That is more than 3 million bpd higher than Russia (second largest producer).
EIA expects strong US production to continue through 2024 with growth driven by rising well efficiencies in US oil rigs.
Globally, crude production growth is expected to slow but still rise by 0.6 million bpd in 2024 with higher US production offsetting the decline from OPEC nations. Expectedly, this has led to a widening premium for Brent crude compared to WTI.
Demand outlook for crude oil remains uncertain. Slowdown in demand growth remains a concern. EIA forecasts global oil consumption to rise by 1.4 million bpd in 2024. This represents a slowdown in growth compared to prior years (1.9 million bpd in 2023).
Slower economic growth translates into lower crude oil consumption. As such, supply-demand dynamic may remain unchanged despite slowing production growth.
NAVIGATING DIVERGING OIL OUTLOOK
With both bullish and bearish drivers for crude oil in active play, a directional position in crude oil might not be able to provide intended hedge for adverse price move. In a market with plenty of uncertainty and characterised by oscillating prices, gamma scalping can be used to harness consistent gains.
INTRODUCTION TO GAMMA SCALPING IN CRUDE OIL
Gamma scalping is an options trading strategy in which a trader continually adjusts their holdings to profit from small price movements in the underlying, while maintaining a directionally neutral position.
Gamma scalping involves dynamic hedging by continually neutralising options delta. Delta is the value by which options prices change for every dollar change in crude oil price. Gamma is the value by which delta changes for every dollar change in crude oil price.
Gamma scalping profits from small & frequent volatility in crude oil prices regardless price direction. With gamma scalping, traders can gain from both upward and downward price moves.
ILLUSTRATING GAMMA SCALPING IN CRUDE OIL
Gamma can be scalped in multiple ways. Common among them involves establishing a long straddle which is a combination of long call and a long put using at-the-money (“ATM”) options expiring on the same date.
Hypothetically, we can follow three simple steps to set up gamma scalping:
Step 1: Buy (“Long”) ATM Call Option and Put Option (aka Long Straddle)
At the hypothetical strike price of USD 70/barrel, premiums required for buying Straddle (calls and puts at-the-money option expiring on 14/Jun 2024) is USD 12/barrel (USD 6 each for call and put) which translates to USD 12,000 per lot. At inception, the delta should be at or near zero.
In practice, delta for ATM calls and ATM puts can differ and the position may have a net non-zero delta. Investors can reference the pricing sheet on CME QuikStrike for realistic options premiums, delta values, and strikes.
The gamma of the long ~0.025 x 2 = 0.05. Gamma is the value by which delta will change for each change in crude oil price.
Long straddle at inception is delta neutral. Meaning, it does not have directional exposure. However, it has long exposure of 0.05 gamma which signals that delta will change when crude oil prices move.
Step 2: Dynamic Hedging When Crude Prices Move Higher
Consider an up-move of ten points with crude trading up at USD 80/barrel. This results in a new delta of +0.5 (due to Gamma of 0.05 and 10 point move in crude prices: 10 * 0.05 = 0.5 per barrel). This translated to delta of 500 per lot of long straddle.
To remain delta neutral, trader needs to sell 5 contracts of CME Micro WTI to balance the increased delta. As a result, the overall position now consists of:
• Long 1 x ATM call option with a strike price of USD 70, with expiry 14/June (LON24).
• Long 1 x ATM put option with a strike price of USD 70, with expiry 14/June (LON24).
• Short 5 x Micro WTI futures contract (MCLN2024) which provides exposure to 500 barrels of oil at USD 80/barrel.
Step 3: Harvesting Gains via Dynamic Hedging when Crude Prices Fall
Imagine crude oil prices fall to USD 70/barrel, new delta is -0.5 per barrel and -500 per lot of long straddle. To remain delta neutral, the trader needs to buy five lots of CME Micro WTI futures to neutralize delta once more. This results in a profit of USD 5,000 (sell at 80 and buy back at 70 per barrel; each lot of CME Micro WTI futures represents 100 barrels).
Overall position now consists of:
• Long 1 x ATM call option with a strike price of USD 70, with expiry 14/June (LON24).
• Long 1 x ATM put option with a strike price of USD 70, with expiry 14/June (LON24).
This trade can be executed multiple times repeating the same steps as above. If crude oil trades down to being with, neutralising delta would involve buying lower and then selling higher when prices recover.
SALIENT CONSIDERATIONS WHEN GAMMA SCALPING
Upfront Premiums: Long straddle requires an up-front cost. Gamma scalping will need to be executed multiple times to break even and recover the premiums. Up-front premium implies fixed downside with a well-defined maximum loss.
Dynamic Hedging: Gamma scalping requires continuous monitoring and adjusting of positions.
Time Decay: Options should be selected with sufficiently large days-to-expiry to minimize effect of time decay. Time decay of the option rise sharply closer to expiration massively shrinking the value of the long straddle.
Long Volatility: High gamma benefits from high volatility. The strategy should be utilized when volatility is expected to rise or remain high.
At Expiry: The options legs may expire at a net loss and require scalping to break-even. Example payoff analysis for different settlement prices for crude oil at expiry:
1. Settles at USD 60/barrel: The put option is US 10 in-the-money and the call option is worthless. Options P&L = USD (10 – (6+6)) x 1000 = Loss of USD 2000. Gamma scalping must have generated more than USD 2,000 to offset this potential loss.
2. Settles at USD 75/barrel: The call option expires worthless and the put option is USD 5 in-the-money. Loss of USD 7,000. Gamma scalping must generate at least USD 7,000 to break-even.
3. Settles at USD 70/barrel: The call and the put option both expire worthless; the entire up-front premium of USD 12,000 results in a loss. To break-even gamma scalping must generate at least USD 12,000.
MARKET DATA
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