Trading Energy Complex Pairs

Includes: XLE, XLF, XLY
by: ETF Prophet

By Jeff Pietsch

Over the last several months, it seems that every other financial blog has opined on the trading relationship between the Energy and Financial complexes -- so what's one more?!

While it has certainly been the trade du jure, it is perhaps one degree separated from the more intuitive Energy vs. Consumer Discretionary trade -- at least for this writer. But how to successfully trade these sectors against one another in an erratic market characterized by rapid rotation?

This article poses one possible short-term quantitative answer to the question using traditional long-short pairings of exchange traded funds, including: the Energy Select Sector SPDR (NYSEARCA:XLE) versus the Financial Select Sector SPDR (NYSEARCA:XLF), and the Consumer Discretionary SPDR (NYSEARCA:XLY), respectively.

Method & Rules

The premise will be to trade mean reversions after statistically extreme sector divergences. After scanning for such divergences, we will then employ pairings of the above ETFs whereby one stock will be held long and the other held short with equal dollar weightings.

The method and rules for this simplified trade follow:

  1. Divide the Daily Closing Log Prices of ETF-A by ETF-B;

  2. Calculate the 15-Day Moving Average of the Derivative Pair;

  3. Subtract the Average from the Current Result and Divide by the Pair's Trailing Standard Deviation ("SD") of the Same Length;

  4. Long the Derivative (Long A and Short B) when the Number of SD's Exceeds -2.2.

  5. Short the Derivative (Short A and Long B) when the Number of SD's Exceeds +2.2.

  6. Exit the First Close after: 1) the Pair has Mean Reverted past Zero; and, 2) the Derivative Ratio Moves Against the Trade for First Time.

Easy, right? The sections below provide trading results for the two pairings over the most recent five-year period ended August 6, 2008 (1,263 trading days). As you will see, results are generally positive but far from consistent. In both cases, results have been strongest in 2008, though performance of the XLE/XLY pair has perhaps been more predictably consistent. No slippage or trading costs are assessed.

Results A ~ Energy vs. Financials (XLE/ XLF)

Results B ~ Energy vs. Consumer Discretionary (XLE/ XLY)

Trading pairs can be notoriously tricky and it is not uncommon for both sides to move against the trader -- just look at all the reported hedge fund losses last month. Careful money management is needed, and the development of non-dollar weightings and intra-day rules may hold you in better stead than the simplified on-close method presented above.

If nothing else, I hope this article points you in the right direction for further study. These days, it certainly beats holding onto a theme based on discretion alone. In addition, you may find that tracking the relative success of various sector pairings provides advance notice of "what is working" beyond the trade du jure.

Addendum: Apparently I haven't been the only one with pairs on the mind. A morning visit to Dr. Brett Steenbarger's TraderFeed blog presents an excellent companion piece to this article. Here is the link to "Divergences and Pairs Trading." Dr. Steenbarger frequently writes about inter-market relationships in addition to his core articles on improving trader performance. Highly recommended.

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