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NEW YORK, Dec 8 (Reuters) - Oil traders who bought U.S. crude call options before OPEC's agreement last week to cut output did not get the windfall they were expecting as the rally in those options fell short of crude's massive surge.
Early last week ahead of the Organization of Petroleum Exporting Countries meeting, traders piled into inexpensive West Texas Intermediate January $60 calls expiring in mid-December with premiums between 6 to 8 cents. The buying pumped open interest up by about 90,000 lots in just three days to a record for that contract.
Call options confer the right to buy a futures contract at a preset price and date. While they tend to rise in value when the underlying contract goes up, the point of the trade was not necessarily to get oil prices up past $60 a barrel, but to sell when premiums rose if oil, as predicted, surged.
Oil indeed jumped after OPEC agreed to cut output - rising by nearly $5 a barrel, or more than 10 percent on Wednesday, after OPEC agreed to cut production - but options premiums rose by only 3 cents day-over-day. That made the trade profitable, just not as lucrative as expected.
"At the end of the day, the risk (in these options) is defined and limited. It's either going to work out in a big way or fizzle out," said John Saucer, vice president of research and analytics at Mobius Risk Group in Houston.
The culprit was implied volatility, a determinant of an option's premium, for January. Volatility for at the money options fell 29 percentage points in the latter half of the week, resulting in the biggest weekly decline since January 2009, according to Thomson Reuters data.
That's what kept the premium - the cost of the option - from rising commensurate with the move in futures, as fewer people jumped in to bet that oil would hit $60 by the mid-December expiration.
Implied volatility was expected to decline, as it generally moves inversely to prices. But the sharp dip came because producers responded to the rally by using complex hedging structures that weighed on volatility, said Harry Tchilinguirian, global head of commodity markets strategy at BNP Paribas.
"We saw a lot more three-way structures used by producers" to hedge 2017 and 2018 production, he said. "These kind of producer hedges are net short volatility overall."
In a three-way structure, a producer buys a put - an option protecting from price declines - close to the at-the-money level and sells a lower-strike put. They also sell an out-of-the-money call, which limits upside. It's essentially a bet on stability, and the buying of one option while selling two is negative for volatility.
Implied volatility for the WTI 25-delta put with a one-month expiration rallied to a eight-month high on Nov. 30 to 57.57 percent, but plunged to 43.16 percent the next day and below 37 percent by Dec. 2. The implied volatility for the corresponding call touched a nine-month high of 52.08 percent, but then slumped to 33 percent by Dec. 2.
Dealers said there was also active buying of one-by-two call spreads, which involve buying at-the-money calls and selling two lower-delta calls further out of the money. Like the three-way structures, that involves more selling of options than buying, which also lowers volatility.
Three trade sources said that one large fund bought 50,000 to 60,000 lots of the WTI $60 Jan calls early in the week at around 8 cents. The fund then unwound some of the position last Wednesday by selling at 10 cents, which lowered volatility. (Additional reporting by Liz Hampton; Editing by Alden Bentley)