Trading Strategy: Oil Stocks vs. Oil

This strategy was inspired by the recent Bespoke post Oil Stocks Outperforming Oil in which Bespoke showed the historical ratio between the price of oil stocks and the price of oil itself. I’ve reproduced their graph below.

Rising values indicate that oil stock prices are strong relative to oil, and falling values that oil stock prices are weak relative to oil.

In this post, I’ll demonstrate a strategy that uses this ratio to trade the oil sector.

click to enlarge

I’m not sure what indices Bespoke used in their study, but the graph above is similar in spirit. I’ve used the Amex Oil Index (XOI) to represent the oil sector and the spot price of West Texas crude to represent the price of oil. ETFs such as Energy Select Spider (XLE) or U.S. Oil Fund (USO) could be substituted with basically the same results.

The next graph shows strategy results from early 1986 “trading” XOI using the following rules: go long at today’s close if the 9-day exponential moving average of the oil sector vs. oil ratio is falling. Close the position and move to cash if it is rising.

click to enlarge

[logarithmically-scaled]

Strategy results are in green, buy and hold in blue, and just for comparison’s sake, the opposite trading rules are in red.

This is a very simple proof of concept so these results are frictionless (i.e. do not account for transaction costs or slippage) and do not include return on cash, but for the sake of argument, these results could have been more or less duplicated using leveraged mutual funds (the only things I trade).

And for the number lovers:

click to enlarge

In a nutshell, this strategy is buying oil stocks when they’ve become cheap (in an intermediate time frame) relative to oil itself, and exiting oil stocks when they’ve become expensive.

The strategy hasn’t been particularly profitable this year, but has at least scratched breakeven (compared to a ~40% loss for buy & hold). Strategy results YTD:

click to enlarge

[logarithmically-scaled]

Conceptually, I think that this strategy makes perfect sense. I also think it has a lot of room for improvement because we’re only looking at oil stocks relative to oil, and not directly attempting to time the oil sector itself.

I’m going to keep this idea on my drawing board and see if I can’t build off of this observation. As always, threre will be more to follow on the subject.

[P.S. At this moment, the EMA of the ratio is rising (i.e. oil stocks are expensive relative to the price of oil) so the strategy is neutral to bearish on oil stocks.]

Geek Note: There are two generally accepted ways to calculate an EMA, which produce slightly different results. Here I’ve used the ((1/Period)*2) method. If your charting program uses the (2 / (Period + 1)) method, simply reduce my period by one. For example, if I’ve used a 9 period EMA, the alternate EMA would be an 8 period EMA.

Comments

[Henrique Si...:]

My experience with trading systems is that they fail when they look the brightest. For the future I suggest you do the reverse. :)

2008 Dec 29 09:45 AM

[Michael S:]

RE to Simmons: I would wholeheartedly disagree. Visit this link to see the independently-audited real-time results of the system's I'm affiliated with.

marketsci.wordpress.co.../

These are all mechanical and were clearly not the brightest before they failed. michael

Jan 07 01:13 PM