How to Trade the Brent/WTI Oil Spread

06/17/2011 9:00 am EST

Focus: COMMODITIES

Traders are anxious to play the spread between Brent and WTI crude oil, and while some interesting chart action is playing out, one trader explains why this trade is a sucker’s bet in current conditions.

I can’t tell you how many times I have heard the question about how to play the spread between Brent and West Texas Intermediate (WTI) crude oil. If I had a dollar for every time, I would be so rich that I would stop giving you these ideas that make your life so easy and drink scotch on my own deserted island all day as my kids get fed mangoes by their baby giraffes!

But I get sick of the sun easily, so let me help you keep your brain from melting while trying to figure this out. Below is a ratio chart of the United States Brent Oil Fund (BNO) against the United States Oil Fund (USO).

chart
Click to Enlarge

There are several interesting things going on in this chart: It shows a stair-stepping pattern higher since BNO was created in June 2010. A measured move higher would put the top in on this stair at a ratio between 1.95 and 2.11. It is in that range now, but then again, there is not a lot of history to rely upon.

There is also a break of a rising channel at 2.00 that the ratio looks to be coming back to retest. It is outside of the Bollinger bands, and the Relative Strength Index (RSI) is working off a technically overbought condition. But the Moving Average Convergence Divergence (MACD) indicator is large. A pullback can follow from those indicators. But playing the spread to tighten is premature. That means don’t do it yet.

There are plenty of oil traders out there that can spout about “backwardation” and “contango” as reasons to trade this spread now. They are wrong. Price does not lie. Do not do it. Wait for a break back below the top trend line in the ratio before you even look at this spread collapsing. Until then, it is in a bullish breakout higher. Once again, that means do not play it. And if you just can’t wait, don’t come crying when it rips higher in your face!

By Greg Harmon of DragonflyCap.com

See related: Oil Spread Trade That’s Pretty Slick

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