Rhymes with Granny

I live in a neighborhood with a lot of character. Some of that character is evident in the nighttime activities on the far west side. Particularly at the NYC Parks and Recreations funded piers. They’ve become the place in Manhattan for young urban transvestites to hang out. It gives the hood a certain edge. In more blunt terms, it means that there are always a number of dudes cruising around in mini skirts.

Being a resident for a while now, I find the phenomena a fascinating little element of New York City living. But out-of-towners can get confused. But being around it enough, it is simple to generalize a few easy rules, such as:

Are those 8″ platform heels —> that’s a dude.

Is the outfit very heavy in denim –> that’s a dude.

Etc. Etc.

As in life as in the market. How often do we see trades that appear one way but end up being very, very different? And from time to time we run across trades that set-up so easy we almost can’t help ourselves from jumping right into bed. But are there indicators that might help us avoid a Crying Game moment?

Common sense questions are a good place to start:

- Are all the ninnies doing it ie is everyone of the same side of the boat?

- Is it too easy / too telegraphed / too good to be true?

- Are the salesmen saying its a “sure thing”?

Please don’t tell me about cash flows, or your sweet model, or your great source. Answers those questions first, please.

Lets take a look at recent example of a trade that was “too easy”.

The USO is an ETF that is meant to track the performance of crude oil. Crude oil is a commodity and not a cash flow producing going concern, so the manager of the ETF must chose a way to track the oil price. This manager’s strategy is to  own front month West Texas Intermediate futures. Thus the manager is required to constantly “roll” the fund’s contracts. For instance, in the middle of the December the manager sells their Dec contracts that expire in two weeks and they buy January contracts.

Starting in Nov of 2008, the USO grew mightily. Shares outstanding stood at 20mn in Nov and reached a high of 160mn by February. That is equivalent to 160k crude oil contracts. The current front month open interest is 350k contracts. The USO became as big as half the market, ie an elephant. And small, intelligent, flexible traders will always try to take advantage of mechanistic large institutions. And if you know that the USO is huge and needs to roll a LOT of contracts around mid month, what do you do? Short what they need to sell (front month WTI) before they do. Buy what they need to buy (second month WTI) before they do.

And starting in December, it worked great for three months (A, B and C)*. You conceivably made ten points on each trade and it worked pretty painlessly.

Unfortunately, I didn’t hear about it until March. At that point, friends were chattering about it. It was covered in the media. Trading blogs mentioned it breathlessly. And so it failed all three common sense questions listed above. And what happened if you put on the trade in March? It blew up. If you took home this very sexy gal, you had a just terrible evening.

As an aside, who suffered from this phenomena? Those that least deserve it, the public. The white line is front month crude and the orange line is the USO. Massive underperformance.

* The first chart actually shows the WTI premium relative to Brent. It’s all basically the same trade though.

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