Pairs Trading: Opportunities in Oil

Trends in the prices of WTI and Brent Crude oil indicate that these futures could be suitable candidates for a pairs trading strategy.

In his last report, 'Equity Pairs: A Trading Strategy', Research Analyst Anthony Grech introduced the concept of pairs trading and explained how it could be applied to the equity market.

His new report demonstrates how the same strategy can be used effectively to generate low-risk profits in commodity trading.

Anthony explores the co-relationship between WTI (West Texas Intermediate) and Brent Crude oil futures, examining recent changes in the price ratio and identifying potential opportunities for pairs trading.

Below is a summary of the latest free report from IG Index. You can access the full version in the TradeSense Databank found in the PureDeal platform.

Potential opportunities

Over the past year, the mean-average price ratio of WTI and Brent Crude oil was calculated as 0.99 [1]. On occasions, however, it deviated to a low point of 0.977 and a high of 1.006.

With pairs trading, you can profit from such situations by exploiting the price divergence between the two futures. This can be done by placing a long position on the 'undervalued' future and, simultaneously, placing a short position on the 'overvalued' future, with the intent of taking profits when the price ratio between the two securities converges back to its historical level.

It is important to note that your exposure to both commodities should always be the same when entering a trade of this type, in order for it to work.

Entering a WTI/Brent pairs trade

WTI, which has historically traded at a slight premium to Brent, has been trading at a significant discount recently. WTI usually commands a premium over Brent because it factors in higher transportation costs and is considered to be of superior quality.

At the time of writing, the price ratio stands at 0.9327. This is because WTI has been sensitive to larger-than-expected build-ups in US Crude Oil inventories, whilst Brent has reacted more to geopolitical tensions in the Middle East and Russia.

Dependant on the ongoing impact of these factors, opportunities may arise to profit from an eventual narrowing of the price ratio towards this year’s mean average.

If you decide that a recalibration towards the mean is imminent, IG Index will enable you to place your pairs trade quickly and simply at the moment you feel is right.

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The above comments do not constitute investment advice and IG Index accepts no responsibility for any use that may be made of them.

[1] Price Ratio: WTI $ per barrel/Brent $ per barrel