Tail Risk In Crude Oil: Friend Or Foe?

Includes: OIL, USL, USO
by: Kris Rymer

Tuesday, Javier Blas of the Financial Times wrote an article titled Traders Fear 'Tail Risks' in Commodities.

Mr. Blas suggests that traders around the globe, including institutional traders such as Barclays Capital, are presently expressing risk aversion to commodities due to "inordinately large" tail risks - especially in the crude oil markets. Mr. Blas supports this contention of risk aversion with quotes from institutional traders citing relatively large tail risks in crude oil prices due to:

  1. tension in the Middle East,
  2. prospects for the economy of China and
  3. concerns regarding the Euro Crisis.

Note: For those who may not know about tail risk, you may learn more here.

These concerns about tail risk are spot on, and they certainly affect the price of crude oil. However, should we really paint tail risk in such a negative light? For traders, especially trend followers, is tail risk really our foe, or is it our friend?

In fact, we know that we cannot have profit without risk, due to works from economists such as Frank Knight. Profit is, by definition, related to profit. So, as traders and trend followers, we really need risk. Thus we need volatility and tail risk, which is arguably the biggest source of profits for trend followers.

It does not matter whether crude oil will go up or go down. We can debate the fundamentals and the economic risks until we are blue in the face. It is irrelevant because prices make news - and not the other way around. News does not make prices. The best measure of tomorrow's price is today's price. What matters is that volatility and risk exists and that we can benefit from that risk with disciplined, rules-based trading.

So embrace the tail risk inherent in commodities - however inordinately large. You cannot profit without it!

Should you wish to participate in the crude oil market, but do not trade futures, you may gain exposure through ETFs: OIL, USO, USL.

Disclosure: I currently do not hold positions in any crude oil or commodity ETFs, nor do I intend to open such a position in the next 72 hours. However, I do have open futures positions in crude oil contracts.