Another Macroshares Oil Arbitrage Opportunity

Back in April I identified an opportunity arbitraging the MacroShares Up UCR and Down DCR shares. The Down shares were overpriced relative to a fairly equivalent investment in USO puts. That play paid off well for me as noted in my last blog post.

However, now that the original up and down shares have terminated MacroShares has launched a new series with a higher termination trigger. The up shares (UOY) and down shares (DOY) just started trading yesterday and surprisingly the volume is fairly low compared to their recently expired siblings. I guess all the gamblers who were betting on oil going down have lost all of their money at this point. Also surprising is the fact that the down shares are not trading at much of a premium to NAV. In fact, yesterday the down shares closed at a 1.4% discount to NAV, which just doesn't make sense to me. It doesn't make sense because these shares are basically LEAPS and LEAPS are worth more than intrinsic value, or NAV in this case.

So this creates an arbitrage opportunity (buy DOY and sell LEAPS) which I took advantage of yesterday morning. However, I only took advantage of it in a small way because this is by no means a risk free trade. Nevertheless, I do believe it's a good bet. Let me explain.

The DOY shares are essentially 1/4 of a put on oil at $200/ barrel. The only trick is that the expiration date is indeterminate because you don't know when the shares will hit their termination trigger (oil at $185 per barrel). This is what makes the arbitrage strategy a bit difficult since any put you hedge the DOY shares with will have a definite expiration date. I chose the January 2010 USO puts because the only other choice, January 2009, didn't have the strike price I needed and I don't know how long it will take for this trade to play out. I didn't want to have to deal with rolling the puts over.

Because USO shares are equal to about 0.8 barrels of oil, $200 oil corresponds to USO at $160 and one put covers about 80 barrels of oil. Since each DOY share covers 1/4 of a barrel of oil I needed to buy 320 DOY shares for each USO put that I sold. I only sold 3 puts, for which I received $16,469.90, and I bought 960 shares of DOY for $14,421.00. I'm cash flow positive on the trade and I should be able to close this out for at least a $2,000.00 gain. In fact, if the DCR day traders start gambling on DOY, which is almost a certainty, we could see DOY become overpriced just like DCR was.

How can I lose on the trade? Like I said, with the expiration of DOY indeterminate there is a risk that the price of oil could shoot up really fast, triggering termination. If DOY quickly expired worthless I'd still have a short position on the USO puts that would have some residual value which I would have to cover. However, I'm gambling that DOY is going to move to a substantial premium before it ever hits termination. I'll let you know how it turns out.

Disclosure: Long DOY, short USO puts

Comments

[John Blothers:]

Great article!

2008 Jul 03 12:25 PM

[fxtrader07:]

good one - one of the rfather few really valuable articles at SA .

2008 Jul 04 04:33 AM

[popeye:]

There is one flaw in your theory. You are assuming that USO = Crude Oil. This is crucial to your hedging strategy and it is incorrect.

USO has susbtantially lagged Crude Oil over last few years. It has big tracking error (to the downside) over the long term.

So, over long term, USO will have larger % move to the downside than DOY. So, you are more the puts you sold on USO will appreciate more than your investment in DOY.

2008 Jul 04 10:08 AM

[panitaxx:]

great article. made a killing with DCR

2008 Jul 04 10:32 AM

[Ray Wollney:]

I don't know if this hedge has any merit or not.

What I do know is that it is not an arbitrage.

An arbitrage is the simultaneous buying and selling of the same security or commodity in different markets to make an immediate, RISKLESS profit.

"However, I only took advantage of it in a small way because this is by no means a RISK FREE trade.

That statement should automatically tell you this is not an arbitrage.

To use arbitrage to describe this trade is an oxymoron.

It is at best a hedge.

2008 Jul 04 12:05 PM

[Daniel Serm...:]

rwollney1

I think you have the definition of arbitrage wrong. I'm sure you looked it up somewhere, but this is for sure arbitrage. Your definition is too narrow. Arbitrage, in general, is playing both sides, both short and long, of a position, in order to take advantage of a spread that the arbiter thinks is to wide.

2008 Jul 07 10:49 AM

[Gary Lucido:]

I just closed out the trade after only 6 days and pocketed $3,665:
www.investingminds.com...

2008 Jul 08 04:33 PM

[Lucid Morals:]

You are basically front running. This is ethically wrong and makes you less credible. I like the way you are approaching oil trading but I think you are a schmuck for putting on a trade and then writing about it. If you want to trade, do it and talk about it after you have closed the position. If you want to educate, wait until adaquate time has passed to put on a trade. Ethics will make your statements hold more value and if you do not care about the value of your statements then why are you writing in the first place. If you just want to toot your own horn, get your lower ribs removed. Gary, you are intelligent and I think this is a good trade. Thanks for posting the comment that after 6 days you have found this trade is no longer valuable to you. You should not have to use such parasitic tactics to be successful!

2008 Jul 09 04:17 PM

[Gary Lucido:]

Well, I thought about this and decided it was absolutely OK. First, I'm disclosing my position. That puts everyone on notice that I might have something to gain from the article and, if they don't trust me, I could be simply pumping. The very fact that Seeking Alpha asks for disclosure indicates that they anticipate people will write about positions they hold. Frankly, I'm turned off when I read someone's analysis and they DON'T have a position. Like...why don't they put their money where their mouth is. Second, I think it has less credibility to write about something after the fact. I could simply make up a bunch of trades with the benefit of hindsight and look brilliant. Third, I'm looking to share the information so that others can profit too.

2008 Jul 12 10:21 PM