Friday, January 28, 2011

WTI vs. Brent arb seems to be reverting starting today

Today I started leaning heavily on the reversion trade.  Long Mar CL, short Mar COIL.  Also short Dec CL, short Dec COIL as a way to hedge against the chance that WTI SHOULD be cheaper than Brent long-term (which I doubt, but it reduces my risk greatly).  In addition, I'm no longer short long-dated WTIs against short VIX futures.

Also, the VIX index is now between the price of Feb and Mar VIX futures as I write this, so I'm long Feb VIX and short Mar VIX futures.

Tuesday, January 25, 2011

Important trend change in the economy

After declining throughout the aftermath of 2008 and basing in the latter half of 2010, bank lending has started to come up out of its base.

If base lending were a stock, I'd buy it right now.

This is important because many people falsely equate printing more money as necessarily causing inflation, while completely neglecting the fact that inflation=money supply (printed money) * money velocity (bank lending in the fractional reserve system).  Now, it finally seems that we may avoid the plight of Japan of the last 2 decades and the US Great Depression experience because the Fed has so forced so much liquidity into the system that money velocity is on the upswing.  It might be no coincidence that the uptrend on the gold/silver charts appear broken, perhaps portending increased interest rates caused by increasing inflation (contrary to popular belief, gold/silver are not "inflation hedges"; empirically, gold/silver in USD terms outperforms during times of low US interest rates).

That's not to say that the housing and muni markets aren't still sickly, US debt credit risks atrocious, and USD fundamentals abysmal.  Of course they still are.  Housing will remain a drag on aggregate US inflation until housing inventories dry up.  But I'm no longer as deflationist as I was before I saw this chart.

Wednesday, January 19, 2011

VLO and refining margins

As an additional hedge to the 3-way arb described in my earlier post Brent/WTI spread very wide, because the short long-dated WTI futures is overweighted in that arb, while RBOB (gasoline) futures are in backwardation, which would indicate further strength in gasoline, all other things being equal, you might want to buy VLO, the cheapest refiner fundamentally, with a great chart to boot, as an additional hedge to the previous trade.

Essentially, the trade as it stands now is a 4-way arb where every part of the trade has positive expectation of profit on its own, but hedges other parts of the trade nearly perfectly.  The legs of the trade are:

Long 1 unit Mar WTI
Short 1 unit Mar Brent
Short 1 unit Dec WTI
Long 1 unit Dec Brent
Short 1 unit either Dec or Jun WTI
Short 1 unit Feb VIX
Short 1 unit Mar VIX
Long some VLO, offsetting the short Dec/Jun WTI

This should essentially make you net flat risk aversion.  I'm currently in every leg of this trade.

Wednesday, January 12, 2011

Brent/WTI spread very wide

Feb WTI crude contracts are now trading at a discount to Brent crude of between $6-7/barrel.  This is unsustainable longer term.  See for some charts of this.

At the same time, contango is widening on the WTI contract.  This is typically bearish for the whole term structure.

So while the Brent-WTI arb would dictate long Feb WTI, short Feb Brent, the contango situation would dictate short further out WTI (like the liquid Dec '11 contract).  So I may do a four-leg trade to reduce risk, reduce margin requirements, while increasing expected return even further: Long Feb WTI, short Dec WTI, short Feb Brent, long Dec Brent.

If you would like to incorporate a third trade idea into this trade, since the long Dec Brent future leg has no edge in and of itself, but was taken as a hedge to everything else, that leg can be replaced with other positions having an edge.  Specifically, as described in  Uptrending Equity: Volatility arb, the steep contango in VIX futures provides an edge.  Because short VIX futures is essentially a long equities market position, and because oil is strongly correlated with the equities market (due likely to the "borrowed currency" status of the USD in the currency carry trade, meaning the correlation is likely to remain high for as long as the interest rate on the USD remains low relative to other worldwide currencies; graphs of oil/SPY correlation and interest rates here: and, the long Dec Brent position could be replaced with short VIX futures.  You will have to figure out for yourself what the appropriate size for the substitute should be.  Naturally, this would use more margin and incur more risk, but would simply combine yet another successful strategy into the trade to eliminate the hedges from each corresponding trade that don't provide any natural hedge.  In other words, by combining the VIX strategy with the oil trade, I can eliminate the long Brent Dec crude position from the oil trade, and eliminate the short SPY or long SPY puts position from the VIX paired trade.

Will look for the Brent-WTI spread to begin converging to get in.