A Simple Oil Trading Strategy That Returned 28% Per Year Since 1987

Includes: EFAV, USO, VYMI
by: Logan Kane

The oil market has some peculiar characteristics that make it profitable to trade over a 1-3 month time horizon. A quick look at what they are and how to profit.

An introduction to the fundamental law of active management, which can help you no matter what kind of investor you are.

A deep dive into the oil trading strategy.

Also, can covered calls work on oil?

How to trade oil futures

Berkeley professors Richard Grinold (pictured on the right) and Ronald Kahn state in their book, which was well read among quantitative hedge fund managers, that the information ratio (explanation here) of a manager is equal to their investment skill times the square root of the number of independently correlated investment opportunities available. They called it the "fundamental law of active management." Here's the formula, for those interested.

Information Ratio = Information Coefficient (Skill) * Number of Bets ^1/2

In plain English, this means that if you want to get higher returns, you have two choices. To make more money investing, you either need to increase the number of bets that your portfolio makes, or to improve the strength of your investment forecasts.

1. The first choice is widely prescribed by financial advisors, which is to diversify your bets as much as possible. By investing in as many different opportunities as possible, you increase your expected return relative to the amount of risk that you take. Index funds are one way to help achieve this.

2. The second choice is to improve the strength of your forecasts. This might mean developing your skill in picking individual stocks, identifying economic trends, or using my favorite method, which is identifying and exploiting the constraints and biases of institutional investors.

This is true whether you day trade, buy dividend stocks, invest with quantitative models, or even just drop $100 per month in a 401k. In truth, there are merits to both approaches. At one end, you have Warren Buffett, who has been proven to be capable of making extremely strong forecasts about companies' future prospects and has made tens of billions of dollars doing so. On the other hand, you have market-making firms and high-frequency traders who trade millions of shares per day and might only win 50.5 percent of their bets. They've likely made billions too, but they don't talk to the media the way Buffett does. There is no right or wrong way to trade, but the information ratio and Sharpe ratio attempt to measure it.

My goal for my own investment model is to have a realized annual risk/reward ratio over 2.0, trading long/short in futures and ETFs over a 2-week to 3-month time horizon. This corresponds to a return of >20 percent annualized and risk of roughly 10 percent annualized. I believe I'll be able to achieve that goal based on my model of systematically exploiting the constraints and biases of institutional investors, which I wrote about here. You can also find my forecasting methods for US Treasuries here, and my full current futures/ETF investment model here (I'm still refining the model, so bear with me). However, props to CME for launching e-micro index futures.

Improving the strength of my crude oil price forecasts

From 1987 to 2014, crude oil futures had an average return of about 9.7 percent per year (I'm referencing this PIMCO study, for those interested). During times when crude oil has a positive expected return, it makes a fantastic diversifier for combined equity and bond positions (better so if you're using a risk parity type setup). Any time you can add something to your portfolio that has a high expected return and isn't fully correlated with equities, you gain from diversification.

However, that's not the whole story. Roughly 60 percent of the time, oil trades in backwardation, meaning the market is relatively tight. During this time, the average annual return is over 28 percent per year. The other 40 percent of the time, oil is in contango, meaning that the market is oversupplied. During these times, oil averages a -16 percent annual return. By using the term structure of the market as an indicator, you can achieve returns on the trade that are roughly double the annual returns of the S&P 500, with a reasonably low corresponding impact on the total volatility of your portfolio.

Source: PIMCO

This data doesn't appear to be cherry-picked, as there are clear economic reasons for crude oil to perform better when there is a relative shortage (see the theory of storage for more). Therefore, adding crude oil to your portfolio when it's most likely to increase in price is likely to decrease your risk and increase your returns in most cases. But why don't market participants arbitrage this away? Well, sometimes they do, and producers respond to the incentive by ramping up production, then the market goes back into contango, oil tanks, and the process starts all over again.

In my investment model, crude oil gets roughly a 15 percent gross allocation when in backwardation (also, gold gets a 10 percent allocation, but the term structure matters little for gold due to arbitrage and ease of supply. The total positions of the portfolio usually total around 200 percent of NAV). I'd also probably short some Canadian dollars to hedge and own some Canadian dividend equities via international dividend ETFs like iShares Edge MSCI Min Vol EAFE (EFAV) and Vanguard International High Dividend Yield (VYMI).

From here, we can further improve the strength of our forecast. West Texas Intermediate Crude Oil is typically more well-supplied than Brent Crude, which is the European equivalent. Thus, over in Europe, the market is usually tighter. Europe is forced to import oil from Russia (and to a lesser extent, the Middle East). This creates volatility, both implied in the options and realized in practice.

WTI/Brent Prices

Source: Econbrowser

Brent-WTI Spread

Source: Econbrowser

We can clearly see two trends developing over the last 10 years. First, Brent crude is more volatile than WTI, and second, Brent has a higher risk of blowing up in the event of a war or supply disruption. The nice thing about this is, all you have to do is look at the term structure to see whether Brent or WTI is tighter. Right now, the market for Brent is tighter. This could change, in which case we'd go back to WTI. Trading oil isn't as easy as trading stocks, but it isn't out of reach for the typical investor with a six-figure brokerage account, either.

Can we use options to do even better?

I have a theory about the oil market, and maybe my readers could weigh in in the comments. In short, I believe that airlines suck at trading oil futures. Forbes seems to agree, in their profile of how Delta Airlines lost 4 billion dollars hedging fuel costs. One of the ways that airlines protect against oil prices rising is to buy call options. Then, my theory would hold, call options on oil should be a little overpriced to reflect the risk premium of insuring against a geopolitical supply disruption. Oil prices (especially in Europe) tend to crash up rather than down, so selling volatility via out of the money call options might be able to turn $100,000 worth of expected value, paid out roughly once per 10 years, into $120,000 worth of net covered call premiums plus capital gains in the underlying position, paid closer to monthly.

Apparently, very few people care about this enough to publish on it, because I found a grand total of one paper on SSRN about it, from a couple of analysts at Standard & Poor's. It has 153 downloads in 10 years. However, it does show outperformance for covered calls on crude oil through a market cycle.

Source: SSRN

How to execute the trade

You have two choices for executing this trade. One will work better for pros, and one may work better for smaller traders.

The "pro" way to execute this trade is to go long crude oil futures that are 2-3 months out (either Brent or WTI, depending on the market), then opportunistically take a look at the implied volatility and bid/ask spreads on the options to see whether the second leg of trade makes sense to you, using a 1-3 month timeframe. The minimum notional value to do the trade this way is about $60,000 to $70,000 (however, the trade will only take up a fraction of this as margin, so you can overlay it against equities and bonds, rather than having to sell them as long as you meet the minimum margin).

The "retail" way to do this trade would be to use the United States Oil Fund ETF (USO). I hate this ETF for the fees and transaction costs they pass through, but as long as the term structure of WTI is okay, you can profit from lending it out to short sellers on Interactive Brokers, which helps your profit/loss numbers. The current term structure is pretty flat for WTI, and the market is tightening, but you'd want to check every week or so to make sure that contango isn't developing.

I did a quick look at the January OTM $13 strike call options for USO, and both calls and puts trade at roughly a 6-7 percentage point premium to the 90-day historical volatility of USO. This is promising.

The puts are actually more expensive than the calls because of short selling constraints (this is not a problem for the futures trade, however), but you can profit from the short borrow rate by lending your USO shares out. Honestly, I wouldn't recommend this covered call trade on USO unless you have market-making experience because USO is a lousy product, and there's no good way for retail traders to hedge it, but teaching you how to think like this can help you identify similar trades in the future. However, if you have at least $500,000 in discretionary capital, you can make some nice money doing the trade the pro way and be able to diversify your equity risk at the same time.

The main risks of these trades come from the inherent volatility in the price of oil (historically, the uncovered trade has a return of roughly 28 percent per year and volatility of 25-30 percent). However, you can size your positions accordingly and boost the risk/return profile of your overall portfolio.

As for the airlines, maybe they'll learn how to trade someday!

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.