Thoughts on Oil and Trading Volatile Markets

I know this is an "Options Trading Blog" but I think I'll also start posting other trading related opinions here also from time to time. Someone asked if I thought oil would be at $100 by year end, and I ended up going into a deeper explanation that I originally thought, and I thought I'd post it here also.

Dear XYZ trader.
i don't think $100, but i think we'll get around $80ish sometime before Sept, then probably pull back to the $70 area again--maybe it pushes back to test the $80 area again by Dec, and potentially make a new high next year that could breach $100.... i think $100 would be too much of a "super-spike" in such a short time-frame (before year-end 2006) for something that is already "front-page news"... example is how gold super-spiked to the $730 area just recently, but it still wasn't as much of a news story as the oil market. these "super-spikes" usually don't last long, as noticed by the near immediate 20%+ correction in gold--super spikes usually occur before its the "easy trade," (ie: the gold spike just described, and the original almost immediate ramp from $48 to $68 in oil LAST summer--Gosh... Come to think of it, I should go dig out my trade confirmation from back then when I went long 1 crude future on the day that turned out to be the last day crude traded with a 4 handle. I shoulda held the darn thing longer, but I was content with dumping it around 52 in only a day or two, if remember correctly. Considering all the darn $$$$ I spend every day in gas at now $3.25/gal and oil in the $70's it should would be nice to remember the "good old days" of only $40 crude...but I digress) Anyway, my point and rationale is, that after something hits the front page and its such a popular trade, rarely will you get the "super spike".

Also,
The geopolitical picture has definitely been the fundamental driver of the crude market the past couple years. This political uncertainty is what has made the energy markets totally volatile, and totally fun to trade! I also I think an equally important factor is the increasingly extensive amount of speculative trading done by hedge funds and the prop desks at big investment banks (the Intercontinental Exchange's (the ICE) amount of electronic trading in these crude contracts has expanded a lot this year. This e-trading is mostly by new players who either can't afford a seat on the NYMEX, or traders who just want to attempt to arb/hedge the NYMEX market when the NYMEX is closed.) You can now trade crude around the clock for 22 hours a day on the ICE without being a member of various exchanges--can just do it through the ICE via an internet connection.

What this all boils down to in my mind is an expansion of both "smart" and "dumb" money, which increases total aggregate demand across the board. While it could be equivalent to a zero-sum gain (ie: the same amount of new "buys" vs "sells"), it probably will more likely result in much more traders/speculators/hedgers being on the wrong side of the market at certain points in the future. As these traders/firms unwind their large positions at likely extreme inflection points in price, the market will either go up or down much further than proper (ie: fluctuate far beyond true fundamental prices). A recent profeesor told me how prices of commodity futures contracts are governed much more by the supply and demand of hedgers vs. speculators, rather than the sole fundamental price of the underlying commodity in a macroeconomic sense.

Obviously some of the price of the actual commodity is priced into the price which the hedger is willing to buy or sell the futures contract, but there is also a speculative component (either an addition or substraction to the actual commodity price) that gets priced into whatever price the futures contract is being traded at by these purely speculative "buyers" versus "shorters". One good example of this was how the oil markets got slammed last October when REFCO went belly up. Apparently their internal prop trading book of energy contracts was completely long energy. When they had to begin bankruptcy proceedings and had to liquidate all assets, going completely to cash, they had to sell all their crude oil contracts before October expiration (which only gave them about 4-5 days to sell 100's of millions of dollars of contracts). This unnatural selling sold oil off to extremely low levels relatively speaking to what oil was trading at before the REFCO liquidation.

A similar "unnatural" situation could occur on the upside if a huge firm or hedge fund is short oil futures and a large, unforseen geopolitical event occurs that spikes oil up $5 overnight and the firm/hedge fund that is short (even worse if they're leveraged up on margin) gets short squeezed like crazy causing the fundamentally acceptable $5 increase, to turn into a sudden and sharp $10 increase over a couple days as the firm buys in contracts to cover their shorts. Obviously, once things settle down prices should revert to the "only up $5" price, but as a trader worried about managing the absolute risk associated with my positions I personally have to understand how extreme price scenarios play out when total aggregate demand in a market has increased greatly. It's actually very interesting how OFTEN extreme prices occur in the tradeable markets, which is why analyzing these markets is so fascinating, and so fun to trade!