Pimp My Trade

Oil Fund Arbitrage Strategy

Posted on March 12, 2009 by Adam

Arbitrage is the practice of profiting from discrepancies in prices between similar assets. Looking at Exhange Traded Funds that track crude oil, I see ample opportunities for arbitrage in the energy space.

I noticed this last night when I was looking at a relative strength chart of USO compared to Crude Futures. USO is an ETF that tracks the value of crude oil. In an ideal world, they should move in a 1:1 ratio, and the chart above should be a straight, horizontal line. A great example of that behavior is this chart of SPY vs. $SPX. SPY is an ETF that tracks the performance of the S&P 500 index. $SPX is the index itself. Notice how the chart is a horizontal line, indicating that the performance of the ETF is spot on.

Looking at the chart of USO against $WTIC, you can clearly see that the chart is not a straight line. Over the past year, the chart shows that USO has vastly underperformed. That is the basis for an arbitrage trade, which works like this:

If you were to sell short a fund that underperforms the market and buy a fund that outperforms, you would profit from the difference in relative performance between the two.

For example, If I bought $1000 worth of DBO, another fund tracking the price of oil, and sold $1000 worth of  USO, I would stand to make money if USO underperforme DBO or DBO outperformed USO. Yesterday was a bad day for crude - DBO was down 4.02%, but USO was down by a whopping 5.50%. Had I been long $1000 of DBO and short $1000 of USO, I would have made $50.50 on USO and lost $40.20 on DBO, for a net profit of $10.30.

Note that I didn’t have to be right on the direction of Crude Oil, only on the relative strength of the two funds. It’s an easy trade.

Noticing this arbitrage opportunity, I did some research on Crude Oil ETFs to find the best and worst performers in the group.

The graph above shows the performance of various oil-tracking ETF’s since July 8, 2008. By far the best performer, outperforming even the futures contract itself, was DXO, which is a 2:1 leveraged ETF (note that a half-cost basis was used for this calculation to account for the leverage). THe worst performers in the group were USO, and OIL, which consistently lagged both futures prices and the other funds.

Starting today, I am going to enter a trade long DXO, short OIL. Since DXO is double leveraged, I plan to use a half position size. For example, i would sell $1000 worth of OIL and buy $500 worth of DXO. Had I started this strategy in July 2008, I would have generated a 22% return by March 10.

I have analyzed this trade on a more detailed basis. The average daily return on the trade is 0.27%, with a standard deviation of 1.69%. I plotted daily returns as a histogram, which appears to show a normal distribution. Based on a normal distribution, this strategy is profitable on about 57 out of 100 days.

This arbitrage strategy is not just applicable to the oil market, but to any market in which ETF’s provide a significant price discrepancy. I encourage you to try and find some more arbitrage opportunities.

Happy Trading