WisdomTree Europe’s director of research, Viktor Nossek has written a note on protecting an oil exposure against volatility, using short ETPs as hedge overlays.
He writes that the recent spate of volatility has been most noticeable in WTI Crude Oil, with implied volatility of over 50 per cent, levels not seen since last year’s crash in prices and representing, he says, a sizeable risk premium over other risk assets, including equities.
“It is likely to remain elevated for longer if China, the world’s second largest economy, cannot switch into a higher gear, fear will continue to grow amidst failed policy intervention so far. This has been largely ignored by markets in the second half of 2014, when crude oil futures fell almost 49 per cent after OPEC raised production and geopolitical crises in the Middle East and Ukraine didn’t not disrupt oil supplies.”
However, the consequence has been that speculative positioning on crude oil has since remained historically elevated with about 27 per cent of open interest in WTI Crude Oil on NYMEX currently speculative, which is effectively more than doubling outstanding futures and options contracts held on a non-commercial basis since crude oil prices troughed at 45 USD/BBL in late 2008.
Nossek writes: “Moreover, the hedge funds and prop desks remain overwhelmingly bullish on crude oil, as almost 70 per cent of the 716K non-commercial futures and options contracts are held as long positions (i.e. commercial traders such as oil wholesalers/distributors are net short).”
Looking forward, Nossek believes that amidst a clouded outlook on the direction of crude, an unwinding of speculative positions (currently 269K contracts are net long) or a significant build-up of bullish bets as a result of the sharp correction in oil prices is likely. “Either scenario means that a significant portion of new money entering the NYMEX exchange to gain oil exposure to crude oil or existing money seeking an exit from oil exposure is likely to be driven by short term positioning.”
There is reason to believe that against the uncertain macro backdrop, with China as the epicentre and the relative large speculative net long positioning, volatility in crude oil may stay elevated, he says.
He recommends that investors with a strategic orientated long exposure to crude oil may consider creating a hedged overlay to protect their portfolios in this environment.
“Simple alternatives to derivatives such as options and futures are short ETPs, which can offer leverage factors of one or higher. Like the case for all investment solutions, they are never free of costs, as there is no such thing as a free lunch. A short ETP tracking crude oil with a high leverage factor (such as -3x) requires less upfront capital to hedge the long exposure than short ETPs with a lower leverage factor (such as -1x). However, due to compounding, the former also requires monitoring and more frequent rebalancing to sustain the hedge than with the latter. Hence there is a trade-off between capital efficiency vs the frequency of rebalancing.”
To see Nossek’s demonstration example, please click here: Nossek’s Demonstration