November 4th, 2011
by J. Clinton Hill
Last weekend, a good friend who manages money at Bank of America inspired me to think about the Euro currency. He asked if this is a good time to time to short the Euro currency (or EUR/USD)? What follows are my conclusory thoughts on the matter. Follow up:
While I am indeed bearish on the Euro which faded resistance near its 1.40 level, I do not have the patience to sit and wait for a significant downward move. This is especially true when using leveraged currency futures. Instead, I have considered another more potentially profitable and less volatile trade that also correlates with the thesis of continued economic weakness in Europe. It is a pair trade that shorts Brent Crude Oil and buys West Texas Intermediate Crude Oil.
Here are a five reasons why I believe this spread will narrow:
- Spread Price Reversion: Most of the oil consumed by the U.S. is derived from West Intermediate Crude (aka Light Sweet Crude) while Europe is more dependent upon Brent Crude. Both of these economic behemoths have gluttonous appetites for oil and, historically, the spread between the two benchmark energy commodities has been +/-3 USD/bbl. Currently, the spread between the two is approximately $17.00 USD/bbl and there is potential for some sort of retracement.
- Economic: EU austerity measures are expected to lead to economic contraction. In fact, EU leaders are banking that reduced expenditures will help to improve member nations’ debt ratios. Energy demand typically has a high correlation to economic growth. Therefore, austerity will translate into less demand for Brent Crude. While economic growth is also at risk in the U.S., it should still outperform the EU in terms of relative GDP growth (i.e. USA @ 1.5% to 2.0% vs. EU @ 0.00% or slightly above in a best case scenario).
- Forex: Swiss and Japanese Central banks have implemented protectionist intervention policies. In any type of escalated ‘dog-eat-dog’ economic environment, there is a risk that other G-20 nations could follow suit. Protectionist intervention intended to thwart undesired trade imbalances ultimately have the perverse effect of lowering the Euro currency simply due to trade balances, which in turn creates another negative feedback in higher energy prices for a devalued currency.
- Fundamentals: Based upon data supplied by the Energy Department, the surplus of Light Sweet Crude inventories at Cushing (OK) have dropped to 31.5mm barrels since peaking in April-2011. Meanwhile, with the death of Muammar Quaddafi, Libya’s production of Brent Crude should gradually come back online as its economy cannot afford the non-monetization of its natural resources. The net effects could lead to an increased demand for Light Sweet Crude and increased supply of Brent Crude.
- Technicals: The price relationship between Brent Crude and Light Sweet Crude is just beginning to show signs that this spread is narrowing. Expressed in the futures market as $Brent:$WTIC, the chart below reveals a violation of the weekly uptrend channel. In the ETF market, for those who prefer simplicity and cost-effective commissions, exposure to this investment idea can be gained via BNO (Brent Crude) and USO (US Oil Fund). The BNO:USO relationship also indicates a bearish crossing below the 22 week moving average. RSI and MACD indicators are already signalling ensuing bearish price action for both the futures and ETFs.
To profit handsomely on this trade, one does not even need to see the existing $17 spread retrace all the way down to $3. Retracements of 50% and 61.8% respectively yield potential gains of @ 41% and @ 50% plus. The likelihood of the Euro making a similar move of this magnitude is far-fetched and undesirable from a systemic macro-perspective. Furthermore, this pair trade is hypothetically less riskier than implementing a short position in Euro futures and more profitable than simply shorting the Euro ETF.
(See charts below for further reference…)
Update: A day after posting this article, a reader emailed and asked if the paired trade is a ratio of 1 BNO short to 1 USO long or should it be another number? After all, BNO was trading @ $74.42 vs. the USO trading @ $35.20 when I wrote the article.
This was an excellent question and it made me realize that I neglected to emphasize that this particular trading strategy is intended to be market neutral. The objective is to allocate equal amounts of capital to both the short and long side of the trade. Therefore, an investor would need to determine the divisor before implementing such a trade and this is simply done by dividing the price of the long position into that of the short position.
For the sake of clarity, here is a case study example:
- The above example assumes that an investor established a pair trade between BNO and USO on October-4th-2011 at ratio of 1 to 2.2. In this scenario, 100 shares of BNO were sold short at $68.05 while 220 shares of USO were bought at $29.91
- Initiating the trade credited the investor with a net proceeds of $225.80 (commissions excluded) and the closing of the trade also generated a gain of $302.00 (commissions excluded). The net profit (combination of net proceeds and gains from closing the position) totaled $527.80.
- Percentage returns may vary mainly due to margin requirements established by individual investment brokerage firms and their respective commissions rate. In this scenario, I use a margin requirement of 30% (typical for most brokers), which means that the net capital outlay will be $2041.80. Dividing the net profits of $527.80 by the net capital outlay (i.e. cost of doing this trade) shows a hypothetical return of @ +25.85%.
In summary, ratio allocation decisions should be based upon one’s suitability for risk tolerance and the conviction of their investment bias regarding the underlying securities. Assigning an equal dollar weighting to both long and short sides of a pair trade essentially creates a market neutral position, which theoretically is more conservative and should be less volatile. What ultimately determines how much an investor profits or loses will be the amount of capital they decide to allocate to the pair trade.
Commodities Snapshot: Oversold For Now, Dollar Holds The Key By EconMatters
Correlation Concepts by John Lounsbury
About the Author
J. Clinton Hill is the editor, author, and founder of Hillbent.com’s Market Direction Blog. He draws upon 17 plus years experience as a professional investment advisor managing separate accounts and as a former broker with Morgan Stanley focusing on advanced equity option strategies for capital appreciation, hedging, and risk management. He is a self taught quantitative and technical analyst and since 1990 has devoted thousands of hours to researching and constructing proprietary models and algorithms related to investment finance. In addition to this, he has also studied gaming and fractal theories and modeled software applications for stock market analysis and intelligence analysis research.