Unconventional Ways to Trade the Oil Panic

by Ivan Martchev | March 8, 2011 6:00 am

As I expected[1], oil has been rallying with the deteriorating news flow out of Libya, along with other problematic headlines from the Middle East.

While there is a lot of oil on the U.S. market right now, this rally is not about the present equilibrium of supply and demand — it is about the future likely disequilibrium if this turns into a protracted civil war that spills over into other countries.

Watching senior Libyan government ministers, diplomats and military personnel defect to the opposition is a clear sign of the popularity of Qaddafi. However, it is surprising to see how fast they were able to organize on a big scale. While statements from both sides are highly conflicting, some experts suggest that neither side has the military might for a quick end of the fighting. The situation might require a coalition-style military intervention in Libya like we had in the first Gulf War.

What Escalation Means for Oil Prices

It is all about oil now with front-month futures making consecutive new highs in the past several days. This situation negates the otherwise clearly improving U.S. economic data until more clarity is introduced into the equation.

There is something going on in Saudi Arabia, too, although there the secret police force is very strong. I think the Saudis are misrepresenting their ability to pump more oil on short notice as such statements have done little to calm the market in the past. Tapping into the USPR will do little to solve the bigger problems in North Africa; it looks to me that we will see much higher oil prices before this is over.

The call options I suggested on the U.S. Oil Fund (NYSE: USO[2]) have been handsomely rewarding, and any put credit spreads will be in due course. When my first article on how to trade the oil panic[3] was written, USO traded below $38. On Monday, it rose almost to $43.

At the time, I didn’t suggest an exact strike and expiration as only experienced traders that know how to manage their own risk should be making such a trade. Looking at the trade now, I think it would be prudent to take half of the originally suggested position off the table and let the other half run and/or roll into April calls.

USO Chart

I am well aware of the roll problem with the USO, where the futures exchange-traded fund (ETF) loses value every time the front-month futures expire and the portfolio needs to be rolled into the next month’s (slightly more expensive[4]) futures. This causes huge problems over time, but it is largely irrelevant over a one- or two-month time frame as oil goes parabolic; the USO will rise slightly less than WTI crude oil futures because of this. I will never recommend USO as a buy-and-hold vehicle — or the U.S. Natural Gas Fund (NYSE: UNG[5]) for that matter[6] — but for short-term trading it serves a valid purpose.

It is impossible to put a precise target on the price of oil, as the situation is highly fluid. Anyone trading this mess must be willing to make a judgment call and get out of positions aggressively on their own.

There is an interesting spread trading ETF that might make sense, too, the FactorShares 2X: Oil Bull/S&P 500 Bear (NYSE: FOL[7]), which does exactly what its name suggests. Introduced in late February, FOL is designed to perform at twice the daily return of the S&P Crude Oil – Equity Spread Total Return Index. The fund does this through a leveraged long position in Light Sweet Crude Oil Futures and a leveraged short position in the E-Mini S&P 500 Stock Price Index Futures.

“Daily” is the key word here as both bullish and bearish leveraged ETFs decline over time if their underlying index stays flat in a trading range. This is because of “reverse compounding” of sorts that magnifies the effect of the old mathematical dilemma that a 50% decline needs a 100% rally to go to break even. Since this is a relatively short-term trade idea, this should not be a huge issue, even though it should be highly volatile.

Too Many Dollars, Bonds?

As to any calls or bullish put credit spreads on the iShares Barclays 20+ Year Treasury Bond Fund (NYSE: TLT[8]) that I had suggested, they clearly have not worked out as well. With a credit spread, the options’ time decay works in your favor, while with a long calls trade, it works against you. It looks to me that if oil keeps going higher on further escalation, we should still see a short-term bullish effect on bonds.

Still, the fact that neither the U.S. dollar nor U.S. Treasuries are seeing a safety bid in a time of a geopolitical crisis says a lot about the monetary and fiscal situation we are now facing. Is this because we’re seeing simply too much supply of dollars and Treasury bonds? It certainly looks that way to me.

  1. As I expected: https://investorplace.com/31488/how-to-trade-the-oil-panic-without-buying-oil-stocks/
  2. USO: http://studio-5.financialcontent.com/investplace/quote?Symbol=USO
  3. how to trade the oil panic: https://investorplace.com/31488/how-to-trade-the-oil-panic-without-buying-oil-stocks/
  4. more expensive: http://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude.html
  5. UNG: http://studio-5.financialcontent.com/investplace/quote?Symbol=UNG
  6. for that matter: https://investorplace.com/25846/is-there-hope-for-natural-gas-stocks/
  7. FOL: http://studio-5.financialcontent.com/investplace/quote?Symbol=FOL
  8. TLT: http://studio-5.financialcontent.com/investplace/quote?Symbol=TLT

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