Earlier this month, oil suffered its steepest weekly decline in nearly three years.
Many market observers believe the move was accelerated by banks and trading firms selling “delta hedging” options to oil producers – and that the same phenomenon could trigger a price spike as well.
But why?
For producers, options act as insurance, guaranteeing they will get at least $70 a barrel for their product, even if the market price is below that level.
But for the dealers who take the other side of these trades, the options are essentially bets that they don’t necessarily want to make. Options traders are generally not in the business of betting on prices, so they “delta hedge” which means they buy and sell oil futures to try to cancel out the unwanted bets.
The unwanted bets traders are taking will only come into play if the price of oil falls below $70 by the time the option expires. In this case, they have to pay the producers to compensate them for every dollar below $70.
The traders could offset this bet by selling futures, which would earn them the amount of money they need to pay off the options sold. But this is only the right trade if the price of oil falls below $70. If the price ends up above $70, the option sellers would not have to compensate the producers at all and therefore would not need hedging.
The way options traders deal with this is to sell futures in proportion to the likelihood of oil falling below $70. Options traders call this the “delta.”
The chart shows the delta of $70 puts sold, or the probability of the price of oil falling below the $70 strike price. If the current price is much higher than $70, then this probability is low, and if it is much lower, the probability is high.
Here’s what’s been happening in the market lately: traders who have sold put options sell more futures as a hedge when the market falls and buy them back when the market rises. The rate at which they must move their positions is proportional to the slope of the probability curve, which is highest when the price of oil is near the $70 option price.
Because of this, their hedging is fueling price volatility, especially now that oil prices are near $70 a barrel.