Goldman knows what’s behind the slide in crude. Or at least they think they do.
Oil of course careened lower on Tuesday, as WTI extended a record losing streak on the way to logging its worst day since September 2015. The oil VIX exploded. WTI is now the most oversold in history.
On Tuesday evening, in a brief post-mortem, we said the following about the harrowing price action that characterized the most recent leg lower:
In any event, there’s not a whole lot to say about Tuesday’s dramatic plunge in crude that hasn’t already been said here and everywhere else, but you can bet that commodities strategists will be out in force on Wednesday attempting to explain things and trying desperately to figure out what comes next.
Well, for Goldman, you can blame momentum chasers and hedging for the dramatic moves.
“Driving the most recent leg of the oil sell-off has first been momentum trading strategies and second, increased selling of crude oil futures by swap dealers as they manage the risk incurred from existing producer hedging programs in a falling price environment”, the bank writes. So this is yet another negative gamma story.
Given that brief excerpt, the rest of the narrative falls neatly into place and really, you don’t even need Goldman to spell it out. But just in case, the bank explains that momentum strategies pushed calendar WTI prices through $60 where producers had hedged their exposure with puts. Dealers (i.e., the people on the other side of those options) had of course hedged those short put positions.
“As the price of crude oil falls, the delta of the short put position will increase”, Goldman flatly notes, adding that the rest of this is “straightforward.” To wit:
As the price of crude oil falls, the probability that the producer will exercise the put option moves closer to one. Upon exercise of the put option, the seller of the put becomes an owner of crude oil, which by definition has a “delta” of one. Consequently, the closer the put option comes to being exercised (i.e., the closer to “in the money” it becomes) the higher the delta of the short put position. The rate at which the “delta” of the short put position changes with changes in the price of crude oil is known as the “gamma” of the short put position. As shown in Exhibit 6, the rate at which the “delta” changes (i.e. the “gamma”) is close to zero for short put positions that are either far “out of the money” (unlikely to be exercised) or “deep in the money” (almost certain to be exercised). However, for puts that are “near the money” (closer to being exercised) the “gamma” on the short put position increases and reaches a point of maximum magnitude. At this point, a decline in the price of oil causes the largest increase in the “delta” of the short put position and a swap dealer that is trying to manage the risk of a short put position through delta-hedging will have to sell the largest amount of crude oil in response to a decline in crude oil prices.
So basically, dealers are being forced to sell more and more oil just to stay delta-hedged and as you can see from the chart in the right pane above, there’s a lot of OI around $50, $55 and $60 strikes, which presumably means volatility is likely to stay elevated as long as WTI is in that range.
Goldman notes that explosive volatility in “such a wide trading band” should discourage the momentum chasers and as far as the outlook is concerned, the bank is tentatively sticking with the notion that whenever we do break out, it will probably be to the upside, but it’s clear that a fleeting brush with $50 on WTI isn’t out of the question “given the large concentration of puts at $50/bbl.”
So, if you’re looking to point fingers for the most recent leg lower in crude, you can thank momentum chasers for driving prices through key strikes and gamma effects for the rest – sound familiar?