Playing the Probabilities in Oil

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Every week I post my High Probability, Mean-Reversion Indicator of roughly 25 ETFs with the most liquid options. The indicator provides a quick glance into the current overbought/oversold levels along with current levels of implied volatility and the associated IV rank.

By consistently going through this exercise, I am awarded with numerous opportunities throughout the year. It’s not foolproof, nothing is, but by staying consistent, and more importantly patient, waiting for an opportunity to present itself I am able to wrap high-probability strategies around the occasional extreme overbought – oversold reading.

Recently, due to the surge in crude oil, the United States Oil Fund (USO) has pushed into an extreme overbought state. Typically when this type of extreme reading occurs, the directional trend stalls or simply pulls back, at least momentarily.

Now, I know I don’t have the ability to consistently “guess” the direction a stock or ETF is headed over really any time frame. But what I can do is consistently wrap a high-probability strategy around an extreme in the market and offer myself an 80%+ probability of success on each trade I place.

And that’s exactly what I want to attempt today in USO.

Let’s walk through the trade together.

USO is currently trading for 63.51 with an overbought reading of just under 87.

So, because of the extreme overbought reading I want to apply an options selling strategy, with a bearish slant, that allows me to create a large margin of error by taking on a trade with a high probability of success.

I did a similar trade in XLE recently that led to some small short-term profits, and I hope to do the same in USO.

The Trade

Again, with USO trading for 63.51 I want to place a short-term bear call spread going out 43 days. My intent is to take off the trade well before the March 18, 2022, expiration date. It could be two days, or two weeks, but I rarely hold my position through expiration.

Once we choose our expiration cycle (it will differ in duration depending on outlook and strategy), we begin the process of looking for a call strike within the February 18, 2022, expiration cycle that has around an 80% probability of success.

If you don’t have access to probabilities of success on your trading platform look towards the delta. Without going into too much detail, look for a call strike that has a delta around 0.25, as seen below.

Since we are focused on using a bear call spread, we only care about the upside risk at the moment. For this bearish spread example, my preference is to go with a trade that has around a 70% to 80% probability of success.

The 70 call strike, with a 78.93% probability of success, works. It’s just outside the expected range, and we can always adjust accordingly if needed. I want to have an opportunity to bring in 13.1%, while keeping my probability of success around 80%.

The short 70 call strike defines my probability of success on the trade. It also helps to define my overall premium, or return, on the trade. Basically, as long as USO stays below the 70 call strike at the March expiration in 43 days we will make a max profit on the trade. But, as I stated before, my preference is to take off profits early and, in most cases, reestablish a position if warranted.

Also, time decay works in our favor on the trade, so as we get closer to expiration our premium will erode at an accelerated rate. As a result, we should have the opportunity to take the bear call spread off for a nice profit prior to expiration–unless, of course, USO spikes to the upside over the next 43 days. But still, that doesn’t hide the fact that with this trade, we can be completely wrong in our directional assumption and still make a max profit.

Once I’ve chosen my short call strike, in this case the 70 call, I then proceed to look at the other half of a 3-strike wide, 4-strike wide and 5-strike wide spread to buy.

The spread width of our bear call defines our risk/capital on the trade.

The smaller the width of our bear call spread the less capital required, and vice versa for a wider bear call spread.

When defining your position size, knowing the overall defined risk per trade is essential.

Basically, my premium increases as my chosen spread width increases.

Bear Call Spread: March 18, 2022, 70/75 Bear Call Spread or Short Vertical Call Spread

Now that we have chosen our spread, we can execute the trade.


Sell to open USO March 18, 2022, 70 strike call.

Buy to open USO March 18, 2022, 75 strike call for a total net credit of roughly $0.58, or $58 per bear call spread.

  • Probability of Success: 78.93%
  • Total net credit: $0.58, or $58 per bear call spread
  • Total risk per spread: $4.42, or $442 per bear call spread
  • Max Potential Return: 13.1%

Again, as long as USO stays below our 70 strike at expiration in 43 days, I have the potential to make a max profit of 13.1% on the trade. In most cases I will make less, as the prudent move is to buy back the bear call spread prior to expiration. Again, I look to buy back a spread when I can lock in 50% to 75% of the original credit. Since we sold the spread for $0.58, I would look to buy it back when the price of my spread hits roughly $0.30 to roughly $0.15, if not less.

Of course, there are a variety of factors to consider with each trade. And we allow the probabilities and time to expiration to lead the way for our decisions. But taking off risk, or at least half the risk, by locking in profits is never a bad decision and by doing so we can take advantage of other opportunities the market has to offer.

Risk Management

Since we know how much we stand to make and lose prior to order entry we can precisely define our position size on every trade we place. Position size is the most important factor when managing risk, so keeping each trade at a reasonable level (I use 1% to 5% per trade) allows not only the Law of Large Numbers to work in your favor … it also allows you to sleep well at night.

I also tend to set a stop-loss that sits 1 to 2 times my original credit. Since I’m selling the 70/75 bear call spread for $0.58, if my bear call spread reaches approximately $1.16, I will exit the trade.

As always, if you have any questions, please do not hesitate to email me or post a question in the comments section below. And don’t forget to sign up for my Free Weekly Newsletter for weekly education, research and trade ideas.