Crude oil has quietly become one of the bigger market success stories in 2017.
After recapturing the $50 handle, West Texas Intermediate (WTI) rallied further in November, and is now threatening to cross $60.
The current narrative in energy markets is that OPEC's coordinated production cuts and increasing worldwide demand are finally having the desired effect.
Checking in on OVX, which is basically the VIX of crude oil, one can see that the metric has trended lower during the rally. A strong inverse correlation that is reminiscent of SPY and VIX.
Given that oil hit 2-year highs, it's possible you are scanning the energy universe for potential trading ideas. If that is the case, a recent episode of Options Jive might be of interest.
On this installment of the series, the hosts explore USO and outline why the traditional "drag" observed in this ETF may be alleviated in the near-term. A situation that may open up new opportunities, depending on your trading approach and risk profile.
As discussed on the show, USO is an ETF that tracks the price of West Texas Intermediate (WTI) crude oil. Due to the impracticality of holding physical oil, USO uses crude oil futures instead.
Mechanically, that means USO constantly needs to roll their long futures position, which equates to selling the expiring near-term contract in favor of purchasing the longer-term contract.
In recent months, crude oil has often been trading in "contango," which means that futures contracts trade at a premium to the current spot price. For USO, that means the fund needs to pay up when executing the roll from near-term to longer-term contracts.
The added cost associated with rolling in a contango situation is referred to as "drag." As you can see in the chart below, that drag has weighed down on USO’s value, despite the impressive rally in crude oil prices:
What makes the current situation even more interesting is that the crude oil price dynamic across the time horizon appears to be shifting.
As noted on Options Jive, crude oil prices have flattened going forward. It's now possible the crude oil market may enter a period of "backwardation," which is the opposite of contango. When backwardation occurs, futures contracts trade at a discount to the current spot price.
If this does occur, the impact on USO could be significant because the "drag" observed recently could be alleviated. In a backwardation scenario, the USO roll would be executed by selling the more expensive contract, in favor of purchasing a less expensive contract.
If backwardation does come to pass, one might reasonably be more bullish on USO under those conditions - especially if one expects the WTI rally to continue.
Given the importance and complexity of this topic, we hope you'll take the time to review the complete episode of Options Jive focusing on USO when your schedule allows. There are several other important pieces of data included on the show that may help in your investment analysis.
If you have any comments or questions on this material, don't hesitate to leave a message in the space below, or reach out directly at firstname.lastname@example.org.
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.