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.