In light of firebombings, riots, and anarchy in Egypt, coupled with social unrest in Yemen, Jordan, Algeria, and Saudi Arabia, call options of those betting on higher oil prices soared to seven times normal activity on Friday.

This weekend we saw the closing of Egyptian banks and the announced closing of Egyptian stock markets on Monday. However, it is hard to know what will happen next week.

To help understanding the possibilities, please consider this analysis of Friday’s crude action.

Bloomberg reports Oil ETF Call Trades Soar to Record Amid Egypt Unrest

Trading of bullish options on an exchange-traded fund tracking crude futures soared to a record as oil surged the most since September 2009 after unrest in Egypt raised concern that protests would spread to major oil- producing parts of the Middle East.

Almost 242,000 calls to buy the U.S. Oil Fund changed hands today, seven times the four-week average and almost five times the number of puts to sell. The most-traded contracts were the February $38 calls, which rose sixfold to 48 cents. The ETF gained 4.6 percent to $37.58.

“Bullish players are binging on call options across several expiries,” Caitlin Duffy, an equity-options analyst at Greenwich, Connecticut-based Interactive Brokers Group Inc., wrote in a report. “The massive upswing in demand for the contracts helped lift the fund’s overall reading of options implied volatility.”

Oil for March delivery increased $3.70 to settle at $89.34 a barrel on the New York Mercantile Exchange. The contract has risen 0.3 percent this week. Oil volume in electronic trading on the Nymex was 1.36 million contracts as of 3:18 p.m. in New York. That’s the highest level since April 13, when volume for both electronic and floor trading reached a record 1.42 million barrels on the Nymex.

Volume totaled 1.01 million contracts yesterday, 50 percent above the average of the past three months. Open interest was 1.52 million contracts.

Crude 15 Minute Chart

click on chart for sharper image

Hedging Plays Push Crude Prices Higher

I was watching crude futures Friday morning (3:00AM Central) and the futures were essentially flat. Friday morning, however, as oil future call buying began, followed by equity call buying on OIL ETFs, oil shot up nearly $4.

What happened is options sellers (the market makers on the other side of those trades), cannot risk being naked short those oil calls and had to hedge by buying futures.

To hedge those short calls, the market makers bought crude futures. This delta hedging activity drove up the price of oil this morning as everyone plowed into the “oil might go to the moon” trade.

No one wanted to be naked short over the weekend. (In a similar fashion, I do not believe JPM is naked short silver futures either, but I wish they would come out and prove it).

If nothing happens over the weekend (which so far appears to be a disproved idea already), oil futures could easily sink next week as the trade unwinds. On the other hand, should unrest spring up in Iran or expand in Saudi Arabia crude prices could soar.

Given that a collapse of the Egyptian government seems likely, and unrest in other areas picking up, if crude prices cannot break north here, then look out below. A short or intermediate-term top is likely in.

For more on the crisis in Egypt, please see …

Egyptian Police Disappear in Widespread Chaos, Vigilantes Defend Homes; Egypt Video With a Message “We Will Never be Silenced!”

Egypt Closes Banks, Stock Market; Protests Spread to Saudi Arabia, Jordan; Saudi King Backs Mubarak; Reflections on Misguided US Policy

Mubarak’s Acts of Cowardice; Obama Calls Mubarak for 30-Minutes; Cell Service, Internet Total Shutdown; Anarchy in Cairo; How Long can Mubarak Last?

Mike “Mish” Shedlock
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