For those of us who think energy prices will continue to vacillate

Confused about the direction of oil and natural gas? Welcome to the club. Traders have been wreaking havoc on Canadian energy stocks, up one day down the next. Much like a Latin two step.

Personally, I have been on the side of lower oil prices. Not that anyone in big oil has been listening. Still, I think a case can be made that longer term – eighteen months or longer – a barrel of oil should be somewhere in the US$45 to US $55 range.

For those concerned about the health of our energy companies with lower oil prices, fear not. They can still ring in some decent numbers with US$50 per barrel oil. In fact, if the market were able to see some stability in the price of the energy products, it may actually bid up the price of energy companies.

The problem today, is finding a way to value energy companies when there is such volatility in the underlying product. Unfortunately, the price gyrations that energy products are experiencing can be affected by news of a bad weather system in the US southwest. Meaning that volatility will most likely, continue unabated.

For option traders, this is an opportunity to play straddles from the long side. The straddle involves buying a call and a put on the same underlying security with the same strike price and expiration date. But to make that leap, you have to think as I do, that the options market is understating the real volatility this sector is likely to experience over the short term; i.e. one to three months.

By way of example, consider a long straddle on Encana (symbol ECA, recent price $66). You could buy the ECA July 66 call at $1.80 and the ECA July 66 put at $1.70 for a total cost of $3.50. Based on these prices, the market is assuming an implied volatility of 28%.

The straddle is profitable if ECA moves more than $3.50 over the next three weeks, which is when the July options expire. The profitable range for ECA occurs if the stock rises above $69.50 or falls below $64.50. Given the trading pattern of the stock over the last three weeks, it is not a stretch to assume that either end of that trading range could be breached.

The straddle can also be profitable, if the market raises the volatility assumption priced into the options contract. For example, suppose that over the next week, ECA rallied $2.00 to $68, and then fell back to $65 rallying again to $66. The stock would be where it started, with one week less to expiry. But if the market actually raised the volatility assumption to say 36%, the straddle would actually be worth $3.80. Making it a profitable trade even though there is less time to expiry and the relationship between the strike price and the stock price had not changed.

Other potential at-the-money energy straddles could be initiated on Canadian Natural Resources (symbol CNQ, recent price $70.50, look at $70 straddle), Suncor (SU, $95, consider $95 straddle) and Petro Canada (PCA, $55.80, consider $56 straddle).