Whatever happened to the XLE USO spread - a forex trading system based on a genetic algorithm pdf

Whatever happened to the XLE USO spread ~ a forex trading system based on a genetic algorithm pdf

Recently Mr. Teetor, a subscriber of mine, has posted an enthusiastic comment on trading the XLE-USO spread that I suggested. While Mr. Teetor has a lot of success trading this spread, I must say that I have lost faith in the cointegrating characteristic of this spread because of two reasons:

1) The spread appeared to have experienced a regime-shift since the historic backtest period before August 2006: the out-of-sample performance of the spread since then did not support cointegration; and

2) The fundamental argument in support of cointegration between XLE and USO fell apart upon closer investigation.

The two reasons are, I believe, intertwined. Unlike GLD (part of a much more cointegrating spread that I discussed and tracked in my premium content area), USO does not actually hold commodity assets in its portfolio. It holds nearby futures contracts in oil. When the USO fund started trading in April 2006, its price per share was very close to the spot oil price. Now, however, USO is trading at about $53, while spot oil price is at about $70.6. How can a fund that is supposed to reflect oil price diverge so much from it after a year and 5 months? The reason is that the oil futures market has been in contango since 2005 or so, i.e. far month futures costs more than the nearby contracts, which results in negative roll-yield for long position in oil futures. In the historic period from which the XLE-USO cointegration relation was established, oil futures market exhibited backwardation: far month futures cost less than nearby futures. This regime shift partially explains the breakdown of the cointegration relation in the present out-of-sample period.

The lesson I have learned from all these is to avoid analyzing cointegration relation when either side of a spread involves futures contracts at different points of the forward curve, at least on a time-scale when the shape of that curve might change. (I argued before that XLE, the other side of the spread, can be modeled as an average over the entire forward curve.) Meanwhile, the fund manager of USO would really have done investors a much better favor by getting their hands dirty, leasing some oil storage tanks and buying some real oil assets rather than keeping their hands clean and dealing in futures contracts alone. After all, retail investors like myself can just as easily buy oil futures ourselves, but we cant very well go out and rent an oil tank.

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Shorting the VIX calendar spread - best forex trading strategy system

Shorting the VIX calendar spread ~ best forex trading strategy system

Lately there were a few interesting discussions in the blogosphere on the profitability of shorting the VXX-VXZ spread. (See Quantum Blog and The Speculators Ball.) For background, VXX is an ETN that tracks the first and second month of the VIX future, which in turn tracks the VIX volatility index, which in turn tracks the volatility of SPX. VXZ is the ETN that tracks the 4th - 7th months of the VIX future. During the period 2009-2010, there were 2 different reasons why shorting this "calendar spread" was profitable:

1) The VIX futures were/are in contango: i.e. the back months futures are more expensive than the front months.
2) The volatility of SPX was decreasing with time.

However, some traders seem to think that either one of these conditions is enough to ensure the profitability of shorting a calendar spread.  It is not. (Otherwise, life as a futures trader would be too easy!)

To see this, lets resort to a simplistic linear approximation to a model of futures prices. From John Hulls book on derivatives, section 3.12, the price of  a future which matures at time T is

F(t, T)=E(ST)exp(c(T-t)),

where E(ST) is the expected value of the spot price at maturity, c is a constant, and t is the current time. If the futures are in contango, then c > 0.

If we assume that abs(c) is small, and T-t is also small (i.e. not too far from maturity), and that the expected value of the spot price changes slowly, we can linearize this formula as

F=(a+b(T-t))*(1+c(T-t))

If the market expects the future spot price to increase, then b > 0.

After a few simple algebraic steps, you can verify that the calendar spreads price is proportional to

F(t, T1)-F(t, T2) ~ bct

where T1 < T2 (i.e. F(t, T1) is the front months price, and F(t, T2) the back months).

This is a satisfyingly illustrative result. It says that shorting this calendar spread will be profitable if

A) futures are in contango and the expected spot price in the future is decreasing; or else
B) futures are in backwardation and the expected spot price in the future is increasing.

So what is the situation today? Will it still be profitable to short this spread? As our fellow bloggers have pointed out, VIX futures are still in contango, but the market is expecting volatility to increase in the future over the last month or so. So this may no longer be a profitable trade anymore.
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