With oil's recent somnolent, low-vol levitation at their back, the number of hedge funds and other speculators who were soothed by the gradual move higher and betting on the success of OPEC reflationary strategy, had recently grown to an all time high, as seen in the chart below showing the number of long net-spec positions in the combined oil futures market.
So when the price of oil unexpectedly tumbled on Wednesday, then continued to slide over the next two days, many were wondering if this sharp reversal in prices would unleash a margin-call driven liquidation scramble.
For now, while the selling has persisted, it has been largely orderly and no major "flushes" lower have been observed following the sharp move on Wednesday. Furthermore, until we get the latest CFTC data later on Friday it will be impossible to determine if the record long overhang had dropped (or perhaps increased further), however what we do know is that according to ICE and CME data, a record number of options contracts traded on Thursday, as Bloomberg reports. The total includes contracts referencing Brent and WTI, and also shows a surge in bullish bets that the former will reach $70 a barrel by September.
While it is possible that the spike in option trading is to hedge existing, predominantly long positions, thus preventing a wholesale sell-off, it is just as likely that the momentum chasers simply rushed to "buy the dip", thus becoming even more exposed, this time with leverage and theta, to continued downside risk.
In total, options equivalent to to than 800 million barrels of crude oil exchange hands yesterday, an amount that is well more than half the total outstanding net long spec positions.
According to Bloomberg, Thursday marked the second time in a matter of months that options trading in the oil market has soared. In late November, investors rushed to make bets that prices would rise as OPEC hammered out its deal to cut production. After both Brent and WTI this week fell the most in more than a year, traders again sought to profit from market gyrations by "buying the dip" only instead of buying the underlying, they rushed into its derivative with substantial leverage, hoping for a prompt bounce.
They may be disappointed... at least the bulls that is, Because the surge in option trading occurred as Brent volatility rebounded to a two-month high and the bearish skew surged.
Furthermore, as Bloomberg notes ten WTI options contracts saw more than 10,000 lots traded on Thursday, with five betting on higher prices and five: on lower, which suggests that at this moment the market appears split as to which way oil moves next. That said, by far the most active contracts signalled further optimism in higher prices: according to Bloomberg, September Brent contracts were among the most active, with record call volumes on bets that prices would hit $60 and $70 a barrel.
The move toward longer-dated contracts comes as investors seek cheap protection against price swings after the next OPEC meeting in Vienna on May 25, according to Nick Williams, a commodity futures broker at GF Financial Markets Ltd.
Meanwhile, while the number of contracts betting on $70 a barrel Brent crude by September rose by about 10,000 lots Thursday, other bullish bets declined.
Brent $60 calls for both June and July saw open interest slip in spite of bumper trading. Traders are likely adjusting their expectations about when a re-balancing will arrive, said Jesper Dannesboe, senior commodity strategist at Societe Generale SA in London.
Needless to say, the expectations is "further down the road."
“The bullish structures may have moved their maturities longer, that would mean they’re starting to feel less confident about a near-term bullish story,” said Dannesboe. “If OPEC compliance stays high and global demand stays pretty strong, the re-balancing is going to happen.”
Unless, of course, demand has been vastly overestimated, in which case there will be no rebalancing, and this time the losses for the bulls will be that much greater.
How this trade plays out is anyone's guess, but at least the option surge explains why both OPEC and hedge funds are not only "colluding" as the WSJ reported earlier this week, but that they are all on the same page, and this time thanks to the decay of calls, there is a particular sense of urgency; should the long-awaited rebalancing, and price rebound, not materialize, the next selloff when it hits, will be far worse.