Investigating dislocations in the oil complex

The oil and basic material complex has suffered quite a downturn in 2015 and also in the beginning of 2016. Equity prices have declined dramatically. Oil and basic material company bonds have also been under quite a lot of pressure from downgrades from the credit rating agencies. Even large-cap companies have seen the yields they have to pay skyrocket. As the truism goes, when market volatility goes up, correlations all head to 1, since everyone sells everything. Having noticed HAL, BHP, and COP bonds going for 4.5% to 6%+, which is a huge spread to Treasuries, one wonders how severe of a downturn the market is pricing in.

The following is the correlation of the changes in bond yield (ought to be inversely related to bond price) and USO returns over the period January 4 to February 1.

	Bond Yield	Equity Price
HAL	-0.064	0.68
COP	-0.62	0.79
BHP	-0.78	0.67

Unsurprisingly, each of these companies equity prices are highly correlated to oil prices at this juncture. Even BHP, which is mildly removed from the oil complex, since it works in many basic materials and mining beyond oil, is highly correlated. It turns out that the bond yields of these otherwise investment grade bonds are also moving with the oil prices except for the case of HAL.

Seeking Yield

Prolonged ZIRP has risk-averse conservative investors to a lot unlikely places. Mike Ashton, the Inflation Trader, who seldom recommends specific investments, has given a low-down on series I savings bond as a last bastion of "risk-free" inflation matching yield. Since TIPs are negative and nominal Treasuries have horrendously negative real yields, there aren't a lot of safe havens that make sense anymore. Investors have piled on corporates, emerging market debt, preferred shares, and even dividend-growers to bump up the scant yields they are seeing everywhere. Today, dividend-payers and growers (Schwab's dividend ETF (based on DJ US Dividend 100 Index) has a 30-day SEC yield of 2.99%) are looking like a relatively good deal when compared to Treasuries. But is all this risk worth it and what about the opportunity cost of sitting on short-term instruments? I bonds are interesting in that they have relatively high current yield (2.2%, the same as CPI-U) and are exempt for state income taxes (2.48% taxable equivalent yield for high income tax states). In fact, when the proceeds are used for educational purposes, it is also exempt for federal income taxes (meaning 3.8% taxable equivalent at maximum income tax rates). The term structure of these instruments are standardized: 30-years but redeemable penalty-free from 5-years. These instruments are not transferrable so there is no secondary market. The downside is that the excess fixed rate of return (set by Treasury) is guaranteed to be zero (which is better than TIPs right now) and each person can buy at most $10k worth of these.

Options Expiration Friday

Today is options expiration Friday and Leading Indicators at 10:00am. Futures currently read as follows:

Contract	Price
ES Dec	1223.00
ZN Dec	130'155
DX Dec	77.840

Cash Secured Puts

Cash secured put writing is a venerable strategy where an investor sells puts while simultaneously keeping enough cash for the duration of the put contracts to cover possible exercise. Note that although puts tend to be exercised upon expiration, there is a significant probability of early exercise. This strategy is typically considered a conservative strategy, in the realm of options strategies at least, because an investor will not have to fork over any additional money to cover margin calls so max loss is capped at the exercise value of the put minus premium from the put writing. Typically, this strategy is utilized when an investor expects the underlying instrument to stay largely flat (i.e., appreciate or depreciate no more than the premium generated from writing the put contract). With an options qualified brokerage account, an investor can easily execute his own cash secured put writing strategy. Some ETF managers (e.g., WisdomTree), however, have also introduced the strategy as executed on broad equity indices in the form of an ETF.

Seeing that this morning was a benign CPI day with no earth-moving news from Europe, I thought that it would be an interesting exercise to look at a volatility-selling options strategy. The strategy is a fairly conservative one, cash secured put writing. My sample is the 341 component subset of the S&P 500 with options activity today (i.e., there are bids and asks). I will be only looking at the nearest to the money strikes to the last traded price of the underlying. The puts expire in less than 3 days (Friday, 11/19/11) so there really is not much time premium left. The returns are computed as put premium (midpoint of the bid and ask) over the strike times the 100 multiplier (i.e., the amount of cash needed in case of assignment). The VIX today (the last time I looked) remains elevated over 30.

The above is a histogram of the cash secured put returns. The horizontal axis marks the returns (put premium/ (100*strike)) and the vertical the number of securities that have that return. The median, mean, and standard deviation for the returns are 0.000675, 0.00101, and 0.00111 respectively. The max is 0.01 for TSS.