Saturday, January 30, 2016

Is now the time for an oil volatility linked ETF?

Unless your head has been buried in the sand for the past year you've probably noticed the extremely precipitous drop in the price of crude oil along with a corresponding rise in crude oil volatility.  Crude oil fell more than 70% from its high of $107.68 set on 6/12/14 to its low of $27.56 set on 1/19/16.  This rapid drop in the price of crude resulted in a more than 450% rise in the crude oil implied volatility index (OVX) within the same time period.

These are the types of opportunities I've learned to wait patiently for and act aggressively upon when they arrive.  Buying an inverse volatility ETF every time we get a huge volatility spike has been a profitable investment over the past couple of years.  I've heard all of the arguments regarding the dangers of being short volatility however I still believe that being short during times of extremely high volatility is an important income producing component of any well balanced portfolio.  The main reason for this belief is that the price discovery mechanism embedded in markets is designed to reduce volatility over time which tends to make inverse volatility a naturally appreciating asset.  Additionally, there appears to be a persistent fear factor embedded in markets that always expects future volatility to be higher than current volatility adding a convenient positive carry component to a short volatility position.

So based the premise mentioned above, shorting oil volatility in this environment would have been a nice addition to my portfolio.  The problem is that there is no easy ETF vehicle to use for gaining this exposure.  Being short volatility through an ETF is a nice fire and forget method for this type of exposure, otherwise you run into a never ending series of rolling options positions which usually results in more headaches and commissions than the position is worth.

So why hasn't any ETF issuer stepped up to the plate to provide volatility related exposure to the most important commodity in the world?  With a robust size of $3.1B as of the time of this writing the United States Oil ETF (USO) seems to warrant a couple of companion volatility and inverse volatility ETFs to help hedge against the extreme price movements in oil.  One reason I suspect is that even though USO is of fairly large size it pales in comparison to equity giants such as SPY which would lead one to assume that oil volatility linked products may not draw enough interest to be worth the trouble.

Even given the size issue I think that there are few things that could be going for any issuer that is first to market.  One is the notion that with inflation at near lows, commodity related investing could become increasingly more important in the years to come making a commodity volatility based instrument increasingly valuable as well.  Another is the potential exploration of alternative ways to extract value from commodity based investing.  By now, I think almost everybody notices the fundamental problem with commodity based funds, which is the significant decay that they experience due to the negative roll yield from a market in contango.  One possible solution to this problem is to pair commodity positions with a corresponding volatility position to help offset this decay effect.  This aspect may make commodity volatility instruments even more important to their respective markets than equity based volatility instruments.  Finally, income investing is becoming increasingly popular based on the increasing number of people reaching retirement every year. As stated previously, income from selling commodity based volatility could be a valuable alternative tool to help round out the fixed income segment of one’s portfolio.

Read Next: Volatility as an Asset Class