Make Your Play and Hedge Your Bets

• ByTimothy Collins, RealMoney Contributor
• On 12:00 pm EDT, Friday July 10, 2009

A bear market seems to bring out the ire in the investing community. Blame ... most find the need to assign blame.

I'm being na�ve. Sure. But I play the hand I am dealt; I play the cards in my hand and the ones I can see on the table. If someone has a better hand than me, I don't blame the cards or the dealer. If I lose, I only blame myself or recognize that I was outplayed.

I've taken leveraged ETFs and played them to the best of my ability. Played them to profits in six out of the last seven months -- and double-digit gross returns this year -- while letting volatility be someone else's problem. I play my cards. I play what I see. I don't complain. And demonizing one type of investment vehicle just doesn't make sense to me.

Admittedly, futures are not my game, but I come back to the idea of oil manipulation. Oh dear, what are all these big companies supposed to do when the price is up here, but demand is down there, and vice versa? Do we lock our prices here or risk it? Simple: Think. Look at your hand, and play the cards. What rules state that you must hedge using only oil futures? I wouldn't be me, though, if I left it there and didn't lay out some controversial hedging idea.

Let's assume I like oil prices right here but I want to hedge my exposure in case the price moves higher. On the other hand, I don't want to eliminate my ability to potential profit if oil moves lower. Simple, just use ethanol! OK, jokes aside, what can we use?

1. Oil futures. Bad. Manipulation. Contango. Zombie buyers. It is like a bad Wizard of Oz sequence. "Gee Toto, we are not in the oil fields anymore. Manipulator, contango, and zombies, oh my!"
2. Leveraged ETFs. Also bad due to all that daily compounding and rebalancing, not to mention the fact that my sources tell me they are just inherently evil.
3. Oil ETFs such as US. Oil . This one may be the worst, because it suffers from contango more often than it benefits from backwardation. It is possible to look at one of the energy ETFs, but since these are tied to the underlying equities including drillers and refiners, there could be too great a divergence, so I do not believe those merit consideration at all.

One possible solution would be to make some of that "bad" work for you.

United States 12 Month Oil and PowerShares DB Oil are two alternative oil ETFs that could be used in place of the USO due to their setup, which seeks to mitigate the effects of contango. We could take a long position in those two securities while simultaneously shorting the USO in an effort to profit from the impact of contango.

Furthermore, we'd add an additional short position in the ProShares Ultra DJ-AIG Crude Oil ETF . I would create the original setup in the following ratio:

• $200 long USL,
• $200 long DBO,
• $100 short USO, and
• $100 short UCO.

This is simply a modified net long position, similar to buying $100 in USL, DBO or even USO, but paired in such a way that over the long term, the grouping actually benefits from contango and volatility, two words that fly out of your mouth when talking about oil prices. The USL/DBO pairing with the USO short is specifically tailored to harvest contango in the oil markets, while the pairing with the short UCO is set up to profit from the value divergence of the leveraged ETF.

Over time, UCO and USO can erode in value even as the price of oil moves higher. That same impact can happen on DBO and USL as well, but history shows us that this scenario has not been as prevalent on their values. This is still designed as a longer-term hedge, but one that could profit in an oil market that moves up, down or sideways.

You can play all kinds of variations that off this concept, and it most likely still requires some form of active management. Also, you can flip this scenario if you are worried about falling prices and use securities such as the Powershares DB Crude Oil Short ETN and the ProShares UltraShort DJ-AIG Crude Oil ETF.

Now deal the cards, and let's take a look at what we've got.