The Market With Unlimited Downside

It’s always important when investing to understand your downside risk. When we buy stocks, as long as we don’t trade on margin, the worst case scenario is a 100% loss on our investment.

But that wasn’t the case with last Monday’s crude oil market. History was made…and not in a good way.

The price of West Texas Intermediate (WTI) for May delivery opened at $17.73 a barrel on Monday morning and then started a shocking slide. And therein lays a lesson about trying to time a market bottom.

To put matters in context, the May contract was set to expire on Tuesday, April 21. Most commodity traders don’t want to take physical delivery of the commodity, in this case 1,000 barrels of oil. Given the COVID-19 induced demand collapse, it wasn’t surprising to see selling pressure the day before the May contract closed.

Searching for the bottom…

As oil prices fell, one person after another called or messaged me to ask if I thought it was a good idea to jump into this market. I repeatedly said “No,” that there were just too many uncertain variables in the oil market right now. When the contract reached $10/bbl, one person said to me “This has to be close to the bottom. How much further could it fall?”

Others were asking me about the implications of actually buying the oil and taking delivery so they could sell it later at a higher price. But that’s complicated. Physical delivery is in Cushing, Oklahoma. You have to arrange for transport and storage.

Don’t get me wrong, there are traders who do this, but it’s not a strategy for casual traders. It’s certainly not one for traders who wanted to cobble together a plan the day before the contract expired.

Because the oil markets are in contango (future prices are higher than spot prices), many companies are storing oil. Even if you could find storage and transport, you’d pay dearly for those services. So much so, traders became desperate to unload their contracts.

Accordingly, WTI did something it’s never done before. It broke into negative territory. At that point the price went into free fall. The May contract for WTI traded as low as -$40.32/bbl, before closing at -$37.63/bbl.

Think about the implications. Imagine that early in the day last Monday you saw that the May WTI contract was trading down more than 70% at $10/bbl. You think “What a bargain. I have to get some of that. It can’t go too much lower.”

It turns out it could go a lot lower than even seasoned traders imagined. If you invested $10,000 trying to bottom fish when oil was $10/bbl, not only had you lost your entire investment before the market closed, you owed $37,630.

I saw the CEO of CME Group — where these contracts trade — explain this the next day on CNBC. As he explained, the potential losses in trading oil contracts are limitless. Invest a dollar and possibly lose ten. Unlikely, but not impossible.

The physical oil market has always been risky for speculators, but unlimited losses are risks regular investors can’t afford. Stick with stocks. You might lose all of your investment, but at least you won’t receive a bill in the mail for an outstanding balance.

Editor’s Note: Our colleague Robert Rapier just gave you valuable insights into the chaos surrounding the energy and equities markets. As he advised, you should stick to stocks.

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