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Trading Oil With USO Could Improve Your Risk Exposure

By Chris VermeulenCommoditiesMay 13, 2022 10:48AM ET
www.investing.com/analysis/trading-oil-with-uso-could-improve-your-risk-exposure-200624175
Trading Oil With USO Could Improve Your Risk Exposure
By Chris Vermeulen   |  May 13, 2022 10:48AM ET
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Crude oil, like most commodities, is not priced as a single data point like a stock—instead, commodities, like oil, trade via futures contracts. A futures contract is an agreement to buy or sell a particular commodity or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quantity and quality specifications to facilitate trading on a futures exchange.

Unlike options, futures contracts do not have a time value component in their pricing. Each futures contract is a standalone contract with its ending date, supply and demand, and market-determined price for the underlying product. Another key difference between options and futures is that while an option gives the holder a right to buy or sell at a specific price, exercising that right is optional. Futures contract performance is a legally binding agreement and is not optional.

ETF VS. FUTURES CONTRACTS

Many products that have futures contracts also have Exchange Traded Funds (ETFs) that attempt to approximate the performance of the underlying product. In the case of West Texas Intermediate (WTI) oil, the ETF United States Oil Fund, LP (NYSE:USO) is a popular product. Shares of USO trade on a stock exchange rather than a futures exchange.

Owning shares of USO is not the same as owning oil futures contracts.

USO invests primarily in crude oil futures and other oil-related contracts and may invest in swap contracts. These investments are collateralized by cash, cash equivalents, and US government debt with two years or fewer maturities.

The objective for USO is for the average daily percentage change in USO’s net asset value (NAV) for any period of 30 successive valuation days to be within plus/minus 10% of the average daily percentage change in the price of the Benchmark Oil Futures Contract over the same period.

While the intent of an ETF like USO is to track the price of oil, there will be tracking variation that could be substantial at times.

An ETF like USO trades continuously, whereas the futures contracts the fund may hold have expiration dates. To facilitate continuity, a fund like USO will sell futures contracts close to their end date and replace those contracts with new contracts that are longer-dated. The futures contracts that USO owns spread out over a range of contract dates.

ETFs like USO trade like shares of stock. That structure carries less risk than trading futures contracts directly. And you don’t need a futures account to trade an ETF like USO. You can even trade USO in retirement accounts like IRAs.

CONTANGO AND BACKWARDATION

We can visualize the futures term structure or the forward curve by plotting the prices of a series of futures contracts over time.

When longer-dated contracts are trading at a higher price than the front-month contract, that forward curve is in contango. Alternately, when longer-dated contracts are trading at a lower price than the front-month contract, the forward curve is in backwardation.

The front-month price and the longer-dated price will meet in the middle somewhere as time goes by. But that does not necessarily mean that oil prices will go down. Over time, the oil price can go up or down, and the forward curve will adjust.

Physical products like oil are often in contango because of the costs associated with storage and transportation. These costs are assumed to make oil for future delivery more expensive. But when near-term supply is constrained, the front-month contracts for sooner delivery can be more expensive, and the forward curve will be in backwardation.

ROLL YIELD

An ETF like USO is maintained by rolling contracts forward over a 10-day period. The closer in contracts are sold, and farther dated contacts are purchased to replace them.

The gain or loss from completing those rolls creates a roll yield that can be either positive or negative.

Positive roll yield exists when a futures market is in backwardation when short-term contracts trade at a higher price than longer-dated contracts. When the market is in contango, the longer-term contracts are more expensive than short-term contracts, and roll yield will be negative.

Currently, the oil futures curve is in backwardation. The contract for one year away is trading nearly $25 lower than the front-month contract. That implies that supply is tighter now than expected in the future.

Backwardation can provide a bit of a tail-wind to an ETF like USO when the fund managers are selling relatively expensive short-dated contracts and replacing them with lower-price contracts dated further out.

CONCLUSION

After many years of buying and selling options using a wide variety of strategies ranging from the simple to complex, I find that a simple strategy like selling puts can be one of the easiest to manage and most reliable for generating regular profits. Don’t make it more complicated than it needs to be!

Trading Oil With USO Could Improve Your Risk Exposure
 

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Trading Oil With USO Could Improve Your Risk Exposure

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Comments (2)
taylor jason
taylor jason May 14, 2022 8:57AM ET
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just keep in mind uso want track spot with a perfect correlation which is the result of how uso is structured; its 50% current month oil future, 47% next month, and 3% following month
Mohd Izhar Muslim
Mohd Izhar Muslim May 13, 2022 4:20PM ET
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Thank you for sharing the article 👍
 
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