Oil Stocks vs Oil Strategy Explored

05Jan09

This is a drilldown (pun intended) on the strategy I shared last week that traded the oil sector using a ratio of oil stocks versus oil.

As a refresher, the graph below shows the (frictionless) results of the strategy in green versus buy and hold in blue, and for comparison, the inverse of the strategy in red, from 1986.

[logarithmically-scaled]

The strategy went long the oil sector at today’s close when the 9-day exponential moving average of the oil sector vs oil ratio was falling, indicating that oil stocks were becoming cheap (in an intermediate timeframe) relative to oil itself.

Reader Russ Abbott of Los Angeles, California responded with a very smart comment. In a nutshell, Russ questioned my oversimplification that oil stocks were becoming cheap relative to oil.

Was it that both were rising but oil stocks had risen less (i.e. oil leading oil stocks up), or that both were falling, but oil stocks had fallen more (i.e. oil stocks leading oil down), or were the two diverging (i.e. oil stocks heading down while oil itself heading up)?

My Response

In the graph below I’ve rerun the original strategy in four different flavors: when the 9-day exponential moving average of oil stocks was rising (blue) or falling (dotted blue), or of oil prices was rising (red) or falling (dotted red).

[logarithmically-scaled]

At first glance it appears that the strategy was most effective when either oil stocks or oil itself was rising (solid lines relative to dotted lines), but that ignores the fact that one of those flavors might spend a lot less time in the market. So the next table looks at daily returns (only when invested):

What can we conclude from the graph and table above?

The “Number of Days” column shows that most of the time the strategy is buying the oil sector when oil prices have been rising but that rise hasn’t yet been matched by the oil sector (i.e. oil leading oil stocks up).

In terms of pure daily return, the strategy has been most effective when oil prices have been falling (but oil stocks have been falling even more), but in terms of volatility-adjusted return, the strategy has been more effective when the oil sector has been rising (but oil prices have been rising even more).

But the most important takeaway is that all four flavors of the strategy have been effective.

My oversimplification was (unintentionally) spot on – regardless of whether the oil sector or oil itself has been rising or falling, the fact that the oil sector has become cheap relative to oil (in the intermediate timeframe we’re looking at here), has been bullish for oil stocks.

Thanks again to Russ for the smart comment. There is nothing better as a blogger than when readers get directly involved in pushing this collective discussion forward.

Happy Trading,
ms

Geek Note: There are two generally accepted ways to calculate an EMA that 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. 

 

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Filed under: Stock Market Sectors, Trading Strategies   |  2 Comments