Wolf Option Trading. Let's see how they trade the USO contango and how to partially offset it.......
The United States Oil ETF, LP (USO) is a twin of The United States Natural Gas ETF, LP (UNG), a futures based ETF that encounters issues with contango. If you are investing in futures based ETFs you should already be familiar with the issue and know how it impacts the funds. Thereby, I am not going to go into great detail about the pitfalls, but simply talk about it briefly.
USO owns crude at $85 and by this time next year the futures are pricing crude at $90 or roughly 6%. If all remains the same, this means that anyone buying USO today will not make money and instead lose money, if oil stays below $90. A year of losing money unless prices go up by more than 6% is never fun.
The bright side of this dark oily substance has many folds. Since oil is denominated in US dollars, you have traders that use it as a dollar hedge trade, bad for oil prices going up when a flight to safety is occuring. However, the world will not always live in fear and when it stops, then the trades get reversed and oil and USO then will go up. Oil has many more types of traders (aside from actual fundamental supply/demand folks) such as inflation hedgers, gold/oil ratio folks, oil/natural gas ratio folks, brent/wti ratio folks and a good amount more I am probably neglecting to mention. Fundamentally, the case for higher oil prices is strong and only further economic weakness would cause prices to go substantially lower.
It is likely oil prices will be much higher in the future than $85, but for folks buying USO they have to factor in the amount of contango they will face in order to see if it is a wise time to buy and hold currently. My take is that is probably early to buy crude at $85 and speculate that it will be above $90 by this time next year. There could be a better entry for a buy and hold investor.
However, everyone always has that itch to be more aggressive or look for more bullish things than may exist. I am not immune and it takes a lot of self discipline to be more strategic and wait for better opportunities.
The only easy way to partially offset contango is by being a net seller of options. Many options strategies are available that allow you to be a net seller of options while being bullish on the underlying instrument. Probably the most attractive strategy in my opinion is selling puts greater than 5% OTM and buying an ATM call spread.
For USO, January 2013 options are the only ones available to express a view past April 2012. January 2013 $25 put options are roughly 32% OTM but fetch a net credit of $2.45. The $34-45 January 2013 call spreads would cost $3.49. A net debit of $1.04.
The trade essentially would get you bullish on oil at $57 without factoring in contango. However, if one assumes that contango would be 15% (random) then one would be long oil at $70. The call spread gives one upside in oil prices up to $115 before getting called away from the trade if there was no contango. If one were to factor in a 15% contango rate, then oil prices would have to be $132 to get called away.
Total profits on the trade would be very high if one were to get called away at $45. The returns against total cash involved in the trade would be $9.96 net profits against a $1.04 net debit. However, that can be deceiving as margin requirements would be higher than the net debit but those vary across brokerage firms. The MVAR would be the better calculation and that would be the cost average one would be assigned USO at. $26.05 is the cost average of the total trade ($1.04 net debit added onto the $25 short puts) and a $9.96 net profit / $26.05 would still get one a 38.24%.
Overall, the trade is a good one for people speculating on much higher oil prices than $85 in a year's time, yet doesn't force one to take on shares at current prices.
Posted courtesy of Wolf Option Trading
Disclosure: The author does not have positions in any stocks mentioned, but may initiate a long position in USO over the next 72 hours.