Saturday, January 3, 2015

Crude Oil and the Black Swan

A Black Swan Event in economics and the markets refers to those rare events that seemingly come out of the nowhere, toss the furniture around the room that is our world, and overturn everyone's house of cards, no matter how cunningly constructed.

A black swan may not portend The End Of The World As We Know It (TEOTWAWKI in the familiar parlance of survivalists who obsess about such things). It does, however, decidedly carry the nervous anticipation invoked by Buffalo Springfield in their 1967 single, "For What It's Worth",

There's somethin' happenin' here
What it is ain't exactly clear

Confusion reigns. Puck is King.

In an essay posted on Jan. 2, I made the case that the steep fall in crude oil prices is business as usual for this particular commodity, and in the broad sweep of history, of little significance. (See: "The crude oil 'crash'").

No one, however, has the time or energy to survey the broad vistas while being pummeled by the flood. For those of us struggling in rushing current of the energy sector, the decline certainly feels significant. Indeed, it feels like a Black Swan Event.

Sadly for those of us who so dearly love the dramatic, it only takes a glance at the chart in my earlier essay to knock down the Black Swan Hypothesis of Crude Oil Pricing. The decline from 2008 into 2009 was an event of far greater magnitude, and of far greater significance, embedded as it was in the collapse of capitalist finance and the consequent disruptions we call the Great Recession.

Two black swans in a decade may be theoretically possible, but they're scarcely credible.

That does not, however, answer the core question posed by the price decline from June 2014 into January 2015: Is it significant?

"Significant" is a slippery word. That which is significant to you is a triviality to me. What is significant today is a minor memory tomorrow.

That which has consequences is by definition significant to a greater or lesser degree. But the crash is ongoing and the future is but darkly seen. Who knows what the consequences might be?

If I know whether the event is unusual, then I can begin to understand whether it is significant, since the every day rhythms of our lives tend to be meaningless once the day is done. Knowledge of whether the event was expected is another pathway to its heart. The significant usually comes wrapped as a surprise.

The most most useful measure I've found of whether market moves are unusual or unexpected and therefore potentially of greater significance is based on the pricing model for options and the subsequent modification of the model's price through the workings of supply and demand in the marketplace.

The model sets a price, and traders bid or ask with that price as part of their fund of knowledge. The resulting trade, however, need not be at the model's price. It depend upon what it takes to close the deal, or to "get a fill" in the parlance of the game.

Options pricing implies a level of volatility -- "implied volatility" -- and therefore a trading range, which is measured using the statistical tools of standard deviation from the mean. Standard deviation expresses its boundaries as upper and lower prices that are expected to contain 68.2% of transactions, known as one standard deviation, or 95% of transactions, known as two standard deviations.

Markets charts and tables generally calculate implied volatility for a year, showing how much options pricing implies prices will move in the next 12 months.

For my own work, I adjust the time period to the actual span that has drawn my interest. In the case of the crude oil crash, the 196 days from the June peak to the January low are the period I cover.

The chart I'm using covers crude oil prices as expressed in the futures contracts for Light Sweet Crude Oil.

Futures, however, don't produce continuous series of implied volatility on associated options, because of the way the contracts market works. Stocks and exchange-traded funds produce much better implied volatility timelines. So I've used the futures chart as I did in the early essay. However, I've calculated implied volatility based on the fund USO, which tracks crude oil prices.

The two diverge a bit from time to time -- futures peaked on June 13 and the fund on June 20 -- but the correlation in price movements is close.

Click on chart to enlarge.
Light Sweet Crude Oil futures 9 months daily bars

Options at the peak were pricing in confidence that 68.2% of trades would fall between $91.956 and $121.59 between then and Jan. 2, for a potential gain or loss of 14%, and that 95% of trades would fall between $28.32 and $50.08 for a potential gain or loss of 28%.

I've marked those levels on the chart above, the 68.2% range -- one standard deviation -- in blue and the 95% range -- two standard deviations -- in orange.

By this measure, the decline in crude oil prices reached a magnitude in September when it became unusual. The price broke below the one standard deviation range. It became highly usual in November when the price broke below the two standard deviation range.

In my experience, the standard deviation ranges are accurate measures of what will transpire in the future course of prices. I expect a price to remain within the one standard deviation range, although I'm not shocked if it moves beyond it. A move beyond the two standard deviation range is, for me, rather shocking.

In the case of crude, therefore, the magnitude of the decline was unexpected.

From all of this I conclude that although not a black swan, the crude oil crash is unusual and unexpected, and therefore has a high presumption of significance.

However, there is more to the story.

Implied volatility tends to move back within the standard deviation ranges. The term for this behavior is reversion to the mean. That also has implications for the price.

The decline has taken about half a year, or 26 weeks. In playing with the concept, I use the current implied mean for that period as a target for reversion -- where volatility is likely to go after stretching beyond expectations.

The last time implied volatility was at its current average for 26 weeks was in the week ending Dec. 27. On that week the futures closed at $63.72. That thought experiment suggests that the price will pause and then recover to that level at some point.

That level is well below the $107 starting point of the decline and well below the $77 lower boundary of the two standard deviation range.

The decline, then, is likely to be persistent. It had an impact, and therefore, in the markets, had significance.
The best discussion and standard text on Black Swan Events the book The Black Swan, written by the Lebanese-Amercan scholar and risk analyst Nassim Nicholas Taleb.

I've read it twice and found it to be both fascinating the life-changing, and shall no doubt read it again. Taleb is quite tough-minded about the rarity of Black Swan Events, a term the popular media tend to apply to anything that gets the newsroom in an uproar because no one recalls seeing such a thing for the past few years. His thinking is a fine antidote to the hysteria that is perhaps the primary risk faced by traders.

I highly recommend it as must reading for anyone who has market exposure. Which is to say, anyone, since we all are exposed, either directly or indirectly.

-- Tim Bovee, Portland, Oregon, Jan. 3, 2015

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Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.

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