I have always entered the stock markets, when scripts were overvalued and exited it,when they were near the rock bottom. My broker used to say that I lost money due to the “volatile markets” . Nowadays, I dread the word “volatility” so much that, I want it to pay for all my misfortunes. Finally I think my prayers have been answered in form of “Arbitrage funds”.

The arbitrage fund takes advantage of the difference in pricing between the cash and the derivative markets. Going long in the cash market and short in the futures market and vice versa. This hedges the risk and ensures that the returns are green in color.

But is that so easy? No it’s not! It important to spot the arbitrage opportunity in the market which is the forte of an efficient Fund Manager. The fund manager thrives on volatility in the market. So did the fund managers lap it up when market provided an opportunity to die for on may 18?

So how did the arbitrage funds perform on the Golden Monday?

The average growth of such funds for 2008-2009 was around 8%p.a. but the average growth for the month of May 09 itself is 5%. Hence, it clearly means that at the 5% growth rate, the average per annum growth will be 60%, This is stupendous, even if one compares growth rate of the best performing stocks in the share market. The arbitrage funds have proved that it performs best, when there is volatility in the market.

The arbitrage funds have proven to be a consistent performer over a period of time. The arbitrage funds gave a return of around 8% even when most other equity funds saw their net asset values (NAVs) falling by over 40 per cent.

From April 2008-09, when the net asset values (NAVs) of mutual funds declined by 30 to 50 per cent and the Sensex also declined by about 60 per cent, during the same period arbitrage funds have given returns of about 8.5 per cent. For arbitrage funds, stock prices are not significant but volumes in futures are of much more importance. In 2008-09, volumes in future trading were about Rs 85,000 core per day and now they have come down to about Rs 15,000 crore per day. For better returns in arbitrage funds, both volatility and volumes are required as they create more investment opportunities.

The most important feature of arbitrage fund is that it generates returns irrespective of whether the markets are in positive or negative. It’s gives returns regardless of the market situation. It’s a win win situation for the investors.

Although, the arbitrage funds are equity linked, the investors should not compare it with normal equity funds. The major difference is that the arbitrage funds are partially exposed to the equity market. They just take the advantage of price difference between the cash and the derivative markets. The arbitrage funds are low risk compare to the equity funds. Such funds render some stability to the portfolio and ensure positive returns in volatile times. It is advisable to allocate a small part of your portfolio to such schemes.

The only downside of this is that the investors are not realizing the potential of the arbitrage funds. The arbitrage fund’s Asset Under Management (AUM) saw a considerable dip during last year, when the investors were vary of any equity linked funds. A part of this can be attributed to the fact that some of the investors are not aware of the real benefits of the arbitrage funds. The other reason can be the investors inability to differentiate between normal equity fund and the arbitrage fund.

The arbitrage funds are a win-win situation for investors. It’s the exact remedy for the volatility in the market . An investor should realize this and make the most of it.

Now you know how to make most of the volatility in the market, get the arbitrage advantage and make volatility pay back to you.

In this tumultuous market environment one unfortunate victim among the many vignettes of market wisdom was the “buy-and-hold” strategy. This strategy has worked almost flawlessly and relentlessly for those who stuck to this notion. But this strategy has come under scanner since it has destroyed nearly 50% of assets and wealth for those who continue to stand by it even when markets around the world came down crashing.

This article is not about analyzing this strategy further but to take a serious look at the oil sector where I firmly believe this strategy will work very well for investors who are going to be committed for the long haul. When I say long haul I mean at least 3 years. Black gold has reversed its furious advance in an equally furious manner and I think the elastic is stretched way too far on the short side now. Moreover, as compared to many other sectors such as banking, housing, retail, and even the technology energy sector, the oil sector offers at least some visibility simply because of vast dependence on it.

Here we will take a look at both Light Crude Continuous Contract ($WTIC) and United States Oil Sector Funds ETF (USO) performances but more importantly we will compare that against the S&P500, obviously the most followed barometer of health of the US markets. Any extreme deviation of USO or Oil futures from S&P500 has generally indicated peaks or bottom that resulted in change of direction of prices in oil.

USO

WTIC

Further we will mostly take a technical look at the oil charts coupled with few fundamental thoughts.

First a technical perspective:

Please take a look at $WTIC and USO charts as compared against S&P500.

1. There is no doubt that the severe correction in oil market as indicated by $WTIC chart that plots Light Crude Continuous Contract – smoothening out monthly expiration volatility was mainly due to mid 2008 speculative bubble.

2. I will also use USO (United States Oil Funds ETF) simultaneously to compare some of the facts. USO vs. S&P500 comparison reveals that back in Jan 2007 USO lagged significantly (almost 50%) to S&P500 and that started massive bull market

3. USOs went in overdrive once it crossed S&P500 performance in Jan 2008. I would say that was an inflection point when USO was valued fairly based on the general health of the economy. Then came perma oil bulls and speculators that fueled most outrageous bubble creation in oil that actually traded almost 80% above S&P500 in June 2008 (on closing basis).

4. Since that time in last 6 months USOs (and underlying continuous light crude contract) has had a whopping hair cut of 73% and many people learnt the “the higher you go the harder you fall” lesson the hard way,

5. What is quite interesting now is that in the process of this carnage, it has again come down about 30% below S&P500! What is even more significant is that S&P500 in itself has gone through an amazing crash in the last six months and yet USO trades even 30% below S&P500 levels!

6. Finally, RSI (this is weekly RSI) continues to show improvement over the last two months even when oil hasn’t been rallying much. A very positive diversion indeed.

7. What we need as confirmation and I believe may happen soon is weekly crossover of $WTIC MACD above the red line.

Now let’s discuss some fundamentals:

Although there is a general consensus that along with weaker economies around the world, oil consumption is bound to decline, some basic facts remain intact:

1. Number of vehicles on the road (note that we are not talking about auto sales) across the world have not gone down due to this market crash. As a matter of fact new vehicles are still being added every day albeit with slower rate.

2. The world by no means will detach itself from its dependence on oil no matter how many alternative energy technologies are making inroads to our daily lives.

3. Oil supply is not infinite, that’s a plain simple truth.

4. With gasoline being sold at average $1.5 (from almost $4) in the USA, more people would want to drive (and drive more) than using any other means of transportation.

With this, I think this presents a great opportunity in oil market for investors who would like to be invested for at least 3 years. There is simply very little downside risk than upside opportunity. Downside risk is of about 20-25% as compare to upside opportunity of about 75-100%. Here clearly the strategy should be to be invested in oil with a 3-year time frame in mind but with sell limit order above 75% of the current price. You can even have that order at 100% profit above current price but that purely depends on your risk taking appetite. I opt for this strategy because when a rally starts in the oil market, it is going to fast and furious. Too many oil bashers are going to be scrambling to cover shorts and that will only add to the pace of the rally and in the process your target may be achieved in much shorter time frame than 3 years.

Having said that, I must caution investors that oil will have extremely tough time crossing $79.86 price level and once it starts backtracking from $79.86 price level, it could trade between $50 and $80 for quite some time. These are the thoughts for the long term but let’s focus on immediate and imminent gains that lie ahead of us.

Good trading!