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A Race Against Volatility And Bearish Sentiment For The United States Oil ETF

Summary Option-implied volatility on oil is at levels seen during the financial crisis, and short-term volatility on the United States Oil ETF has soared. While current momentum and fundamentals strongly favor the bears, it seems a recent large long-term bet against volatility is the best risk/reward trade on the United States Oil ETF. An analysis of the timing of various United States Oil ETF trades shows a strong bearish short-term opinion that is very reactive and a telling dispersion of longer-term opinion. On March 5, 2015, Barron’s Blogs published a short article on a large bet against volatility on the United States Oil ETF (NYSEARCA: USO ) called ” Big Options Bet Sees Oil ETF Rangebound into 2017.” The possibilities intrigued me because USO enjoyed a remarkable 5-year period of range-bound trading before the current plunge. After the bounce from 2009 lows, USO hit a high of around $46 in 2011 and a low of $29 once in 2011 and again in 2012. An extended period of relative tranquility has been rudely interrupted Directionless, long-term bets seem very reasonable especially given the runway allowed to close-out the trade at a profit well ahead of expiration. The key quote from the blog post: Energy-sector analysts continue debate the supply and demand picture, but one trader in the options market stepped up to the plate with a notably large, long-term wager oil stability. Andrew Wilkinson at Interactive Brokers noted the so-called ‘straddle’ position, which involved the simultaneous sale of ‘put’ options and ‘call’ options that expire way out in January 2017. Options are contracts that allow investors to buy or sell shares at a set price at a specific period of time. Selling options requires a bet against the underlying equity trading “in the money” by expiration. For call options, it is a bet that the underlying will close below the strike price plus the option premium. For put options, it is a bet that the underlying will close above the strike price minus the option premium. Selling BOTH call and put options on the same underlying is a bet that the underlying will stay within a range over time AND that volatility will generally decline over this time. If the underlying falls too far or gains too much too soon, losses could be great enough to force the trader to abandon the bet at a large loss. The Barron’s blog indicated that the big trade will work as long as USO remains within the range of $12.30/share to $25.70/share. It did not provide the specific strikes, so I directly reviewed the Jan 2017 strikes for large increases in open interest. After this process, I concluded that the swell of negative short-term bets combined with the dispersion of opinion on longer-term bets makes a directionless bet more intriguing. I used the options information in Etrade.com to look at the open interest on individual options as of the close Friday, March 13, 2015. The January 2017 calls with the largest open interest have strikes of $19 and $20 at 21,199 and 23,626 options, respectively. The January 2017 put options with the largest open interest have strikes of $19 and $20 as well at 20,178 and 17,975 options, respectively. There are no other strikes that even come close to these. Looking at the history of open interest, I found that the Jan $20 calls and Jan $20 puts have experienced steady increases in open interest since mid-January and early February, respectively. On the other hand, the Jan $19 calls and Jan $19 puts have both experienced large leaps in open interest. The open interest on the call options more than doubled to about 12,500 options on March 5th. The open interest on the put options went from a mere 2,500 or so to about 12,500 on March 5th. In both cases, traders have clearly piled into calls and puts on top of the initial surge – perhaps in imitation of the short straddle, perhaps as a result of differing interpretations on the implications for the large options trades. For reference, I looked at the other long-term options available for trading: the January 2016 expiration. Open interest in the January 2016 options is quite diverse. For call options, the top open interest sits at $25 with no other strike anywhere close to the 44,445 options. This is of course, right at the top of the range that the January 2017 trader is betting on. There are a cluster of call options ranging from 34,667 to 20,988 open interest scattered across $18, $20, $21, $28, $35 and $30 strikes in descending order. For put options, the $16 strike has an open interest of 52,625 with the $18 strike at a close second with 41,748 open interest. In the case of the call options, clearly some of the bets are very speculative. The calls at the $35 strike have been bought mainly in three separate chunks once in each of the months of November, December, and January at prices around $1.10, $0.45, and $0.17, respectively. So from the lens of individual options on a longer-term basis, the bets for or against USO represent a spread of market opinions. On a short-term basis, the opinion on USO is definitively negative although sentiment has hit even more negative levels before the big sell-off started. This sentiment has created substantial premiums on puts options. Schaeffer’s Investment Research calculates an open interest put/call ratio based on the options expiring within three months. It represents immediate market sentiment. The chart below shows three large spikes in the ratio; only the third turned out to be significant. Yet, traders still rapidly got more (relatively) bullish as the sell-off got underway. After hitting a major low, the ratio only tentatively stair-stepped its way higher until it finally soared in the past month AFTER USO made its last all-time low. The overall open interest put/call ratio stair-stepped tentatively until AFTER USO made its last major low In other words, the market only recently started to accept the bearish nature of the trading in USO as a result of the bearish fundamentals of on-going inventory builds and STILL rising production in oil (not to mention the contango conditions which promise to drag USO further down as the fund rolls over futures positions). Last week, Kuwait suggested that OPEC will continue its production policy in its upcoming June meeting. Also last week, the International Energy Agency (IEA) said …U.S. supply so far shows precious little sign of slowing down. Quite to the contrary, it continues to defy expectations. The organization does not expect production growth to slow until the second half of 2015. U.S. crude inventories are now at a record 468M barrels. (See Reuters ” IEA sees renewed pressure on oil prices as glut worsens” for more details on these developments). I suspect the issue of supply cuts will finally get forced when the marginal buyers of oil have to exit the market for lack of storage. At THAT point, perhaps some kind of sustainable bottom in oil will begin. In the meantime, the pressure on oil prices has created a surge in related measured volatility. The Bank of England recently published this spider chart showing option-implied volatility for oil is at levels seen during the financial crisis. Volatility across financial markets has expanded rapidly from last year’s levels – oil stands out as having reached levels of volatility equal to those of the financial crisis Schaeffer’s Investment Research calculates its own volatility index, the SVI, on individual equities. I believe it uses the front and second month options for its calculation . The SVI for USO has surged to tremendous highs but it has actually come off in recent weeks, likely a reflection of the relief from USO’s jump from recent lows. It took a while for the market to accept the tremendous downside potential on USO. The volatility index did not even reach a new high until the sell-off was about 3 months old. The volatility index on USO peaked just after its recent low. Source: Schaeffer’s Investment Research The behavior of the SVI suggests that the market in USO is very reactive rather than predictive. The extreme in the option-implied volatility on oil suggests that we are closer to the end than the beginning of the volatility spike in oil. If volatility measures on USO, like SVI, manage to make fresh highs, such a move could represent a final washout of negative sentiment. Time seems to be on the side of the big seller of the straddle on January 2017 options. Like the open interest put/call ratio, it took the failure of OPEC’s November meeting to prop up prices for USO shorts to get really serious. In other words, there was a lot of latent expectation (hope?) that OPEC would succeed in efforts to manipulate the market. Shares short on USO are now back to levels last seen in the summer of 2013. Note how that ramp evaporated quickly after USO declined mildly for a few months. Shares short on USO were sitting at a major low one month into the sell-off… Here is a close-up showing how fast shorts piled up after the OPEC late November meeting. For example, shares short soared over 50% from December 1 to December 15. …and shares short did not take-off in earnest until December (after OPEC could not decide to cut production to try to prop up prices) As of the time of completing this piece, USO cracked a new all-time low as WTI crude hit lows not seen since March, 2009. The mild optimism that built from the earnings reports of various oil companies has faded in the wake of the market realities that continue to pressure oil lower. United States Oil ETF makes a new (intraday) all-time low shortly after opening for trading on March 16, 2015 Source: FreeStockCharts.com As I mentioned earlier, I think a major market event like an actual decline in U.S. inventories or the complete filling of storage capacity might be required to signal a more sustainable bottom in oil prices. Ahead of that, selling long-term volatility while premiums are high could be the best risk/reward trade available on USO. Until a major market event, the shorter-term momentum looks firmly in favor of the bears. Be careful out there! Disclosure: The author has no positions in any stocks mentioned, but may initiate a short position in USO over the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Note that I may open a short and/or long position on USO in the next 72 hours. See article for more details.

The History Of The Global Equity Portfolio

One of the nice things about thinking of the world in macro terms is that you are less inclined to fall victim to a fallacy of composition. That is, in the financial world we tend not to think in terms of aggregates so we often extrapolate personal or localized experiences into broader concepts which often results in mistakes. The most common economic fallacy of composition is thinking that if you save more then you’re better off, therefore everyone else should save more. This obviously can’t be true at the aggregate level because if everyone saved more then everyone would have less income. Likewise, in “the markets” we often think of “the market” as being something like the S&P 500 (or worse, the Dow 30) when the reality is that the “stock market” is a global market that is much broader than the S&P 500. And the financial markets are much broader than the stock markets. I got to thinking about all of this as I was going through the Credit Suisse Global Investment Returns Yearbook ( see here ). They had this fabulous chart of the dynamism of the global equity market over the last 100+ years: This chart is interesting because it shows a number of things. First, the USA was once a relatively small slice of the total market cap of outstanding stocks. Second, the reason the USA has performed so well over the last 100 years is, in large part, the result of a massive capture of market share by US corporations. This has huge implications for portfolios going forward. There is, in my opinion, a strong likelihood that the USA will lose market share to foreign firms as emerging markets become the growth engine of the world and the US economy matures and slows. So a slice of global equity market exposure not only makes sense for broad diversification, but also when considering a strategic allocation towards potentially higher growth regions. This image also shows how important it is to be dynamic and forward-looking in your portfolio to some degree. John Bogle recently made headlines for stating that a US investor shouldn’t be invested abroad. I’d be willing to bet if Bogle had been in the UK in 1899 talking about his portfolio preferences, he would have said a UK investor should stay fully invested in the UK. Why even bother investing in an emerging market like the USA? I am sure that investing in the USA back then looked fairly silly to a foreign investor. That was obviously a huge mistake. The point is, the future composition of the outstanding mix of global financial assets will change and investors who shun forecasting and some degree of necessary dynamism in their portfolios are very likely to generate returns that will be based on recency bias and extrapolative expectations (expecting the future to look like the past). One of the big lessons from history is that the future rhymes, but it rarely repeats. And a little bit of intelligent forecasting about what the future might look like could go a long way to helping your portfolio in the future. Are you Bullish or Bearish on ? Bullish Bearish Neutral Results for ( ) Thanks for sharing your thoughts. Submit & View Results Skip to results » Share this article with a colleague

‘The Wisdom Of Insecurity’ In The Stock Market

Over the past few years, the idea of “passive investing” has increasingly resonated with the general public. Money has rushed out of actively-managed mutual funds and into index funds at a rapid rate. Most recently, the passive investing ethos has grown so strong it now reminds me of some hard-core religions that take an unwaveringly literal interpretation of their founding texts. In the case of passive investing, these founding texts are the “efficient-market hypothesis” (EMH) and “modern portfolio theory” (MPT). Created and developed by ingenious men with noble intentions, these theories put forth wonderful arguments for the wisdom of the crowd and the incredible value of diversification, among others. Like most religious texts, however, the main problems arise in their interpretation and implementation. As Alan W. Watts explains in The Wisdom Of Insecurity , “the common error of ordinary religious practice is to mistake the symbol for reality, to look at the finger pointing the way and then to suck it for comfort rather than follow it.” Investors, too, must think critically about the effectiveness of these theories when it comes to practical application rather than take them literally on blind faith. It pays to remember that blind faith in these sorts of mathematical models leads even nobel prize winners to disastrous results. As my friend Todd Harrison likes to say, ” respect the price action but never defer to it .” Clearly, there is value in understanding and incorporating the ideals of these theories. There is also danger in simply deferring to them because the costs of their shortcomings can, at times, overwhelm the benefits of their wisdom. Like the Long-Term Capital boys learned, as soon as you really need to lean on them they vanish like a cheap magic trick. Where these theories go wrong in their practical application is that they both assume there are only rational participants in the markets. While the crowd may be right most of the time, there are clearly times when the crowd is not rational (note the preponderance of manias throughout the history of finance). In fact, the proprietors of these models have acknowledged this Achilles’ heel themselves. The most successful professional investors like Warren Buffett, Paul Tudor Jones, John Templeton, George Soros and Jim Rogers, know this well. Their methodologies are even built upon the idea that an intelligent investor can get ahead by taking advantage of those times the crowd becomes irrational, the antithesis of the EMH and MPT. So saying you believe in passive investing is fine and, in fact, I’ll grant it’s better than most of the alternatives. It will work great most of the time. But know that, just like some fanatics deny evidence that disproves the idea that cavemen and dinosaurs coexisted, you are denying the overwhelming evidence that suggests its foundations are simply not to be relied upon during those rare times when market participants abandon rational thought for panic or euphoria. Make no mistake, those selling this idea of passive investing are selling a very good product. I firmly believe it’s a large step above most of the alternatives out there, more so in the case of those selling it at a minimal cost . But I fear investors are also being sold a false sense of security today. I believe investors passively buying equities today are doing so under one of two false assumptions. They either believe that future returns will look something like they have over the past 40 years or that because the market is totally efficient it’s currently priced to deliver risk-adjusted returns that are acceptable given the current low-yield environment. The first assumption is something I have called the ” single greatest mistake investors make ” and it’s a trap even the Federal Reserve admits it regularly falls into. The second assumption runs into the problem of the evidence which suggests there is a very good likelihood returns from current prices will be sub-par , if not sub-zero over the next decade. And the reason returns are likely to be poor going forward is investors have pushed prices to levels that nearly guarantee it. In my view, passive investors have irrationally relied upon the idea that the market is rational, and therefore attractively priced, in pouring money into equity index funds, sending equity values to heights never before seen (on median valuations) virtually guaranteeing themselves they’ll be disappointed. Just because the future of the stock market is bleak doesn’t mean investors should ignore these facts or have them withheld from them. Ignorance may be bliss but it is not a valid investment methodology. Those with a religious sort of belief in passive investing and its main tenets need not abandon it to acknowledge its limitations. In fact, a little insecurity would go a long way for the growing hoard of passive investors in today’s market.