There Will Be Profit

Your latest phone and your latest girlfriend have something in common, they will become obsolete sooner than you think.

Apple and your subconscious are working overtime to ensure that.

The last decade has seen a technology boom and an oil bust.

Financially, intellectually and morally we have seen peak oil come and go in short order.

It's quickly becoming obsolete.

The financial term for obsolescence is 'contango'.

Contango describes assets which become obsolete overtime. The canonical example are equity options which lose their value as they near expiry.

This contango is embodied in the Vix, and means it's costly to hold onto Vix related products over time.

Usually assets benefit their owners over time however.

Oil only rarely exhibits contango, and normally buying oil futures maturing far in the future are cheaper than those shorter term contracts, making holding and 'rolling' near to expiry contracts for longer term contracts a nice little earner.

Here is a comparison of two oil funds. They are pretty synchronised.

However, over the past week, month, quarter, half year, year, 5 years and entire history(!) DBO (Powershares ETF) consistently loses less than OIL (iPath ETN).

If we short OIL and long DBO we may have the guts of a winning strategy.

The Sharpe Trajectory shows that DBO minus OIL comes into its own however during '08 because OIL does spectacularly bad during market crashes and the ensuing contango.

OIL buys up near month futures contracts, in order to mimic headline spot oil prices, during contango markets however it has to buy high and sell low which leads to large losses. DBO on the other hand spreads its holdings out across different maturities, which reduces the impact of contango.

DBO loses -8% pa; OIL -16% pa; and DBO minus OIL returns +8% with a Sharpe of 0.64.

Further enhancing this strategy along the lines of the Mojito with Vix might be really interesting.