Brent/WTI Spread as a Signal in the Oil Market

The Brent/WTI spread measures the difference between the prices of 2 major crudes: American WTI and European Brent. Due to differences in production costs, chemical composition, transportation costs, etc. prices for Brent and WTI are practically never equal: there is some difference between these grades of oil - the spread.

If the Brent/WTI spread widens or narrows too much, there is a high probability of market inefficiency. In order to eliminate this market inefficiency, traders can conduct arbitrage transactions: buying / selling a cheaper grade of oil and simultaneously selling / buying a more expensive one. There is an expectation that the spread will return to a historically more equilibrium value.

Let's find out whether it is possible to create an effective trading strategy based on the Brent/WTI spread.

Strategy

To determine the optimal difference between the prices of Brent and WTI oil, which the spread should strive for, we will use simple moving averages (SMA) of the Brent / WTI spread with a period of 20, 50, 100 and 200 days.

Moving averages have been discussed in more detail in the study: Price Bounce From the 200-Day Moving Average.

Entering the market - buying a cheaper grade of oil and selling a more expensive one at the opening of the next trading day if the Brent / WTI spread is greater than the SMA (expectation of a subsequent spread narrowing)

OR

Entering the market – selling a cheaper grade of oil and buying a more expensive one at the opening the next trading day if the Brent / WTI spread is lower than the SMA (expectation of a subsequent spread widening).

Exiting the market - a reverse transaction at the close of the trading day (if buying was the first transaction, then the exiting the market through selling, and vice versa):

• At the end of the next trading day after entry
• At the end of the 2nd day after entry
• At the end of the 3rd day after entry
• At the end of the 4th day after entry
• At the end of the 5th day after entry
• On the opposite signal, i.e. when the Brent/WTI spread value became less/greater than the SMA again

The strategy will be evaluated according to the following criteria:

• The average rate of return reflects the relative change in the quotes of financial instruments in percentage. A positive value of the rate of return indicates the profitability of the strategy, a negative one indicates a loss. 

The average rate of return (D) of a financial instrument is calculated using the formula:

D = Σ P (%) / n,

where:

n is the number of trades;

P (%) – the percentage of change in the quote of a financial instrument at the time of fixing a position, is calculated as follows:

for buy positions

P (%) = (position closing price - position opening price) / position opening price * 100%

for sell positions

P (%) = (position opening price - position closing price) / position opening price * 100%

• The total rate of return (TD) is the sum of the profits from all trades. The greater the value of the total rate of return, the greater the profit brought by the signal during its testing period. 

• Maximum drawdown (MaxDD) is the maximum loss in percentage terms from fixing unprofitable trades for the entire testing period. The lower the value of the maximum drawdown, the better the trading signal works.

MaxDD = | min ( DD₁: DD_n ) |

DD_n = TD_n – max ( TD₁: TD_n )

where:

n – number of trades;

D – rate of return;

TDn – total rate of return of n trades;

DDn – drawdown at the time of closing the n-th trade;

MaxDD – maximum drawdown.

Analysis of the obtained results

For variable parameters, the following designations are used: 20, 1; where:

20 (the first number) - SMA used when testing the strategy. Possible values: 20, 50, 100, 200.

1 (the second number) – daily candlestick, on which the position is closed. Possible values: 1, 2, 3, 4, 5.

Not a single combination of SMA parameters and an exit candlestick did not provide the strategy with a positive rate of return. At the same time, it can be noted that with increasing time in a position, the effectiveness of the strategy improves. That is, the expansion of the time range between the entry into the trade and the exit from it leads to an increase of the rate of return, but the passage of a certain period of time is not suitable as a signal to exit the position.

This means that another criterion should be used to exit the trade. Therefore, let's turn to the results of the strategy with an exit from the position on the opposite signal: if the entry into the transaction was when the Brent/WTI spread exceeded the SMA value, then the signal to exit is the fall of the spread value below the SMA, and vice versa.

In case of exiting the trade on the opposite signal, the strategy demonstrates a positive rate of return with any SMA. At the same time, the strategy using the 20-day SMA (0.24%) has the lowest rate of return, while the highest rate of return is achieved using the 200-day SMA (0.48%).

In terms of minimizing drawdowns, the strategy with the 200-day SMA (47.54%) and the 50-day SMA (52.23%) has the best result.

It is natural that when using a longer SMA, the number of signals for entry and exit decreases:

• SMA 50 generates 2.2 trade signals per month on average (approximately 1 trade per 14 days)
• SMA 100 generates 1.64 trade signals per month on average (approximately 1 trade in 18.5 days)
• SMA 200 generates 1.4 trade signals per month on average (approximately 1 trade in 21.7 days)

In terms of the combination of parameters of maximum drawdown, rate of return, and frequency of transactions, the best results are for strategies using the 50-day SMA and 200-day SMA.

Detailed results are shown in the Appendix:

XLSX (0.04 MB)Brent WTI spread as a signal in the oil market.xlsx