Identifying Arbitrage Opportunities in Today's Energy Market Utilizing Portfolio Optimization, the Efficient Frontier Method, Risk Management and Market Correlations

Abstract

This paper outlines an innovative technique for identifying and subsequently optimizing superior investments in the energy sector, both from the point of view from the individual and institutional investor. The first step presents how to organize perspective energy stocks and then subsequently calculate expected returns based on historical stock prices. The expected return results from the selected energy stocks are then contrasted against the S&P 500 performance over the same period to eventually illustrate the energy stocks generally performed significantly better than the market over the past 5 years. The next step outlines how to calculate and determine the optimum energy portfolio utilizing advanced portfolio theory and the efficient frontier methodology. Analysis of this optimum portfolio indicates that the optimal portfolio mix, for the given stocks, is comprised of nine energy stocks and his heavily leveraged in Super Major stock. Finally, risk mitigation strategies are discussed and a workflow for optimizing portfolio diversification is presented. The results of which indicate that seven individual stocks were needed to effectively diversify a portfolio of positively correlateable stocks to a point where the standard deviation of the portfolio would be below 8%. This information can be used by investors to identify trends and arbitrage opportunities in the energy sector. In addition, this information can be used by operating companies to effectively contrast their performance versus their peers and the sector as a whole in an effort to attract new investors and secure market confidence. Additionally, individuals and institutions can use the information and techniques presented to optimize their own risk management strategies.