Options Brief - Hormuz Hopes Douse Oil

Summary

On Monday, oil prices dropped by approximately 5% while US markets were closed for Memorial Day, driven by progress in US-Iran ceasefire talks and increasing expectations that the Strait of Hormuz could reopen. This development led to European stocks reaching a two-month high.

Market Snapshot

• S&P 500: 7,473.47 (Friday close, +0.37%); futures up 0.65%.
• Nasdaq 100: 29,481.64 (Friday close, +0.42%); futures up 0.85%.
• STOXX 600: 631.64 (Monday close, +1.04%), highest since early March; DAX +2.01%, Euro Stoxx 50 +1.95%; FTSE 100 down 0.64% due to UK energy exposure.
• WTI Crude Oil: Approximately 91.76, down roughly 5% on Monday.

Market regime indicates a low volatility bull phase with the VIX at 16.59 and the S&P 500 trading 6.95% above its 50-day moving average.

Options Angle

The CBOE Volatility Index (VIX) is at 16.59, indicating a low-volatility environment. However, the CBOE SKEW index at 137.39 suggests that investors are paying a premium for out-of-the-money downside protection. The total put/call ratio surged by 44% on Monday, indicating significant hedging activity amidst a rising equity market.

Strategy Insights

1. Bullish Risk Reversal

With the SKEW index indicating a premium for out-of-the-money puts, a bullish risk reversal strategy can be employed. This involves selling an out-of-the-money put to collect the premium and using the proceeds to buy an out-of-the-money call, allowing participation in potential upside without a large net cost. The main risk lies in the short put position, which could incur substantial losses if market sentiment reverses.

2. Long Straddle on Energy

Given the uncertainty surrounding the Hormuz negotiations, a long straddle strategy could be beneficial. This involves buying both an at-the-money call and put on an energy instrument, allowing for profit regardless of the direction of the move. The Energy Select Sector SPDR ETF (XLE) is suggested as a vehicle for this strategy. However, if oil prices remain stable, the position may incur losses due to time decay.

Conclusion

The current market dynamics indicate that the Hormuz trade is influencing oil prices and European stocks positively. Elevated SKEW and the surge in put/call ratios suggest that institutional investors are hedging while participating in the rally. For options traders, the setup supports both a risk reversal to capitalize on potential upside and a straddle to maintain exposure to the uncertain outcome of the Hormuz negotiations.