How to Play Defense on USO

On Dec. 7, I wrote about turning our bearish put option position in the United States Oil Fund (USO - commentary - Cramer's Take) into a put calendar put spread, in which we were long the January 70 USO puts (UNAMR, purchased at $2.40) and short the December USO 67 puts (UNAXO, short at $0.80). The net cost basis of the calendar spread became $2.40 - $0.80 = $1.60.

Well, crude oil has rallied more than $4 on Wednesday, and USO has rallied against the "negative delta" in our bearish calendar put spread. (Negative delta means that as the stock goes down, our option position appreciates, and as the stock rallies, our option position declines in value.) That means it's time to reassess and readjust the position from a bit of a defensive posture.

The UNAMR option has declined in value to $1.40 x $1.55.

The UNAXO option has declined in value to $0.10 x $0.15.

Since there is almost no value left in the UNAXO option, I am buying to cover that option at $0.15.

I will remain long the UNAMR option. The net cost basis of my bearish UNAMR will now be $2.40 - ($0.80 - $0.15) = $ 1.75.

Obviously this is a sub-optimal interim result for the position. But this is an illustration of how we can play defense in the options market when things don't go exactly as we would wish.

Here's what the position's risk/reward curves look like before covering the short UNAXO option.

Click here for larger image.

Source: CBOE Options Toolbox 5.0, TheAgileTrader.com

And here's the position's risk/reward curve after covering our short put.

Click here for larger image.

Source: CBOE Options Toolbox 5.0, TheAgileTrader.com

The position's delta (rate of change), if we own 10 contracts, is now -300, which is to say that for every dollar USO moves lower from here, the position will appreciate by $300 and for every dollar that USO moves higher, the position will decline in value by $300.

The gamma of the position -- the rate of change of the rate of change -- is also negative, however, so if USO moves significantly lower, the delta of the position will become greater in a negative direction (moving to, e.g., -400, then -500 as the stock moves lower), and if the stock moves higher, the delta will move toward 0 (moving to, e.g., -200, then -100).

Given that there's still more than a month before January expiration, the theta (time decay) of the position remains small.

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At the time of publication, Oliensis was long United States Oil Fund, although positions may change at any time.

Adam Oliensis is president of Dog Dreams Unlimited, a guaranteed introducing futures brokerage, and editor of the trading service The Agile Trader. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Oliensis appreciates your feedback; click here to send him an email.