Trading oil with exchange-traded products is often misunderstood by retail investors, but it becomes even more complicated for those who want to trade with leveraged exchange-traded notes.
Unless investors completely understand how these instruments work, they should avoid trading them.
It is safe to say that most traders will never look at a 190-page prospectus.
But with the recent popularity of oil investing, let's look at triple-levered oil ETN VelocityShares 3x Crude Oil (UWTI) as an example.
First, what is an ETN? It is a senior, unsecured debt security that a bank issues.
A senior debt security is the first tranche of debt that a company must pay out if it goes out of business. Unsecured means that a loan isn't backed by an underlying asset.
These notes are tied to a benchmark. The bank promises to pay the investor the performance of the benchmark, minus fees.
UWTI, which is backed by Credit Suisse, tracks the daily movements of the S&P GSCI Crude Oil Index. But it comes with three times the index's daily gain or loss.
So a 1% rally in oil would cause UWTI to rally about 3%, while the inverse is true for a 1% fall.
The price fluctuations in oil are extremely volatile. Couple that with three times leverage, and these instruments are extremely unpredictable.
This is due to volatility drag, a term used in the world of professional quantitative analysts. Although it is present in all prices due to negative compounding, the effect is amplified and noticed more easily in a levered ETN such as UWTI.
But volatility drag is a simpler concept than it may seem. It is basically the notion that a loss hurts more than an equal magnitude gain.
Consider this simple scenario as an example.
Say an account makes 10% one week and loses 10% the following week. If an investor started with $100, the account would go up to $110 and then down to $99.
Notice how the same percentage gain and loss puts the investor at a net loss in the account. It won't result in a break-even scenario, as initial intuition might suggest, and that is due to negative compounding.
Volatility exacerbates negative compounding. The greater the fluctuations in price, the more negative the effect.
Now imagine three times leverage applied to this scenario.
Here is another example but this time with the three times-levered UWTI.
Suppose the oil index started at $100, gained 10% one day and then lost 9% the next. Sounds like the investor has made money, right?
But with the leverage applied, UWTI would gain 30% on day 1 and fall by 27% the next day. For simplicity's sake, let's set UWTI at $100 a share.
Look at the chart below to see the final values of the oil index and the leveraged ETN.
The index has no net change, but UWTI is actually lower than where it started. The leverage under the hood is behind this negative performance.
Now imagine this compounding effect on returns over a long period of time.
Many investors fail to acknowledge the complexity of trading an ETN such as UWTI, reducing it to simply guessing whether oil will be up $20 by this time next year.
They don't realize that they are making a realized volatility bet, which is a measure for how much price moves up and down.
If the price moves erratically, realized volatility will be high. If it moves in a smooth, drip-drip path, realized volatility will be low.
And more realized volatility will equate to more volatility drag. As shown above, that will negatively affect long-term returns.
Let's return to the oil example.
Say price rises and the path is smooth. UWTI will greatly outperform by avoiding the volatility drag.
But say the price action is far more erratic, while still ending up higher than it started. Then UWTI will suffer greatly due to the negative compounding from volatility drag.
The graphs below illustrate this effect:
In each example, the oil index rises to about 131 from 100. But look at the difference in the paths taken.
In the example on the left, the index finishes at 131. Notice how it took the drip-drip path, with relatively small fluctuations in price. UWTI finishes at about 171, which is a large gain, so the index has a 31% gain and UWTI a 71% gain.
On the right, the oil index still reaches 131 but had a much bumpier ride getting there. UWTI ends up right around 100.
The index gains 31% gain but UWTI rises 0%, that entire bumpy ride for nothing even though oil still rose significantly.
This is the risk in trading in leveraged ETNs. It doesn't matter if an investor's conviction in the underlying index is correct because horrible performance can still occur from the volatility drag.
It all depends on the path taken.
And if an investor is wrong, kiss a significant portion of the account goodbye. And maybe head to a casino, because there might be better luck there (or at least free drinks).
The administrators of the UWTI ETN actually talk about this in the prospectus, but few take the time to read it.
Investors in it for the long term should stick with outright oil futures and stay away from UWTI, VelocityShares 3x Inverse Crude Oil ETN or even United States Oil Fund.
Don't reduce trading an account to simple gambling.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the securities mentioned.