The record run-up in crude futures prices on the New York Mercantile Exchange over the past month has been attributed to speculators, US-imposed sanctions on Iran, a deep draw in US crude stocks, mounting tensions between Turkey and the Kurds in northern Iraq or pick a reason, any reason.
But few commentators have focused on the role of options on the price of crude futures. Open interest in NYMEX crude options on futures hit a record 3,903,651 lots as of October 29, handily feeding into prices soaring to an all-time high of $93.80/barrel.
With prices trending higher, the risk exposure lies with those short calls. Being short a "naked" call is the most dangerous position for any options trader since risk is unlimited as prices move higher. As prices trade above a strike price, those who have sold the calls are required to buy futures to neutralize the position, or what is known as delta hedging.
In plain English, the delta is the amount by which the call option will increase or decrease in price if the underlying future moves by one tick. In this case, the higher the price goes, the shorter the trader will become, feeding into the buying frenzy in the futures market.
When prices broke above $90.07/barrel, the previous all-time high, October 25, option traders short the December $90.00 calls scrambled to purchase futures contracts, what one source referred to as "panic." Buy stops placed by option traders at the $90.10 level to neutralize their positions sent the market soaring in the final minutes of trading that day. At that time open interest in the $90.00 call was over 50,000 contracts. As of October 29, open interest in the December $95.00 and $100.00 calls was 10,656 and 49,809 contracts, respectively.
This type of heavy open interest in what are currently the out-of-the-money strikes leaves the market vulnerable to additional price spikes should prices continue to trend higher. Look out above.
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