Everything I have learnt about trading oil through ETFs

When I started trading independently few months ago, I began with stocks. I picked some popular stocks such as Apple and Amazon and some not so popular ones such as Extra Space Storage and Public Storage. I would look at my P&L every few minutes to see how my portfolio was doing. However, there was not much I could do if it was doing poorly because since I work at a hedge fund, I am not allowed to sell my stocks within 30 days of buying them. This made me feel a little helpless and to be a honest, it’s boring. This is why I started trading ETFs.

ETFs are great. Not only do they allow me to trade intraday but they also, indirectly, allow me to short. Again, due to the industry I work in, I am not allowed to trade futures and engage in short sales. ETFs allow me to go long and short! A colleague of mine recommended I check out an ETF called FAZ. This ETF is meant to go against the Russell 1000 Financial Services Index. Without knowing much about how 3x leveraged ETFs work, I decided to start trading FAZ to hedge against the market. This was around February when the market was going down. Turns out this wasn’t a good investment because as soon as I invested in FAZ, the economy started recovering and FAZ declined. Of course, I could have switched to FAZ’s counterpart FAS which goes in the direction of Russell 1000 Financial Services Index but I didn’t and had to accept some loss. As I learnt more about trading ETFs, I shifted my attention to trading oil.

Oil, a commodity, is mainly traded through derivatives (i.e. futures and options). Two very popular ETFs that allow you to trade oil are UWTI and DWTI. UWTI is long oil whereas DWTI is short oil. Both are 3x leveraged which means that they are 3x as volatile.

So what have I learned about trading oil in the last few months? Here you go:

1. Supply and Demand matter the most – Since oil is a commodity, its price fluctuates with supply and demand. The higher the supply, the lower the price. This is the cause of recent decline in oil’s price. Major oil suppliers (i.e. Saudi Arabia, Russia) have been flooding the market with oil which has driven its price down. What’s great is that the US government publishes official inventory count every week on Wednesdays at 10:30am. If you can analyze the report quickly, you can predict how oil would do for the rest of the day or next 2 days. For example, last week crude oil inventory was down 1.37M barrels which caused oil price to rise!
2. Oil moves with news – Trading oil is not easy. You have to stay up to date with every single oil related news. For example, few months ago, any comment Saudi Arabia’s oil minister about agreeing to a production freeze would send oil soaring whereas any comment by Iran’s oil minister about no possibility of such a deal would crash oil prices. Moreover, there are news about supply outages that have a huge impact on oil prices. Few weeks ago, news about Canada’s wild fire in its oil sands region helped boost oil prices.

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3. Oil moves with USD – Oil is traded in US dollars which means that its price moves with US dollar rate. For example, as EUR/USD goes down, oil prices go down and vice versa. Why? Consider a European trader with Euros looking to buy oil futures. As EUR/USD rate goes down, our European trader’s Euros are worth less in USD which makes oil less attractive. Oil’s correlation with USD exposes it to a lot of macroeconomic factors. For example, just few weeks ago when the FOMC meeting minutes revealed the a rate hike is more probable than previously thought, the USD strengthened and caused oil price to crash.
4. Oil is very volatile during key hours (pit open, London close, pit close) – West Text Intermediate (US Oil benchmark) is traded on NYMEX where pit trading opens at 9:30 EST and closes at 2:30 EST. You will see most volume being traded around these times even though markets are still open after pit closes. Oil prices see a lot of fluctuations during these times. If you are an institutional trader who is trading in large volumes, you need to keep track of traded volume to know when you can load or offload your positions.
5. Follow the trend – When it comes to trading oil, trend is your friend. Do NOT go against it! There have been times when you know oil should be going down because of increasing supply from producers like Iran but recent events such as strike by oil workers in Kuwait keep boosting the prices. When you see a trend, it’s wise to follow it even if it doesn’t make sense in the long run.

Besides these points, I have learned these things about 3x leveraged ETFs:

1. Do NOT hold them overnight – unless you have a strong case, avoid holding this highly volatile ETFs overnight. You might go to bed in US thinking you made a good gain but you don’t know what news might come from Middle East or Russia before US trading opens which can erase all your gains. Of course, the news can be in your favor too but it’s a huge gamble which you should avoid.
2. Do NOT hold them long term – these 3x leveraged ETFs are known for their decay. What that means is that their price doesn’t move proportionally with their underlying commodity (oil) proportionally in the long term. For example, if the price of UWTI is 25 dollars when oil futures are 45 dollars doesn’t mean that this relationship will still hold a month from now when oil is back at 45 dollars.
3. Cut your losses – It’s difficult to admit you made a mistake and cut your losses but if you don’t, these leveraged ETFs can cause some serious damage to your portfolio. Instead of continuing to lose money with your position and hoping for a comeback, it’s better if you cut your losses and invest that money in the other direction. Trend is your friend, take advantage of it!

I would like to emphasize that 3x leveraged ETFs are not for everyone. They are very volatile and a lot of newbies get burnt trading them. Add oil’s volatility to that and you have a lot of risk management to do. However, if you trade with strict rules such as not holding overnight and with tight stop losses, you can earn handsomely.