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Build Your Own Crude Oil Trading Strategy

When it comes to crude oil, the price is just the beginning. In addition to trading oil as a standalone commodity, investors commonly buy and sell a variety of oil-backed securitized assets, including commodity futures contracts, oil company stocks, ETFs, and a range of other derivatives to speculate on price fluctuations in the crude oil market.

To learn if investing in oil is right for you, check out Should You Add Oil to Your Portfolio?

It makes sense since oil is one of the most commonly used commodities in the world, and the demand for it has been broadly consistent, making it popular among investors. About 32 billion barrels of oil were produced in 2021, pegging the total value of new crude oil at roughly $2.9 trillion annually. Within the oil market, investors and producers track two major benchmarks, brent crude and West Texas Intermediate (WTI)

As a result, the futures market is just about as active as the stock market among commodities traders, highlighting the importance of developing and executing a carefully planned trading strategy when considering wading into the oil markets. After all, commodity trading differs from investing in the stock market.

Buy-and-Hold vs. Algorithmic Strategies

Traders tend to think about their strategies in one of two ways: short-term and long-term.

Those with a longer-term view tend to focus on buy-and-hold investing strategies, which are more passive and involve holding an asset for an extended period with the expectation that it will increase in value. With a buy-and-hold strategy, the investor mainly ignores short-term price movements in favor of broader market moves.

However, in the commodity markets, a buy-and-hold strategy can fall victim to long periods of low or negative returns for oil, which does not always appreciate steadily over the years. The price of oil is highly variable, and while it has historically risen over the long term, short-term volatility and supercycles can catch beginner traders off guard.

Oil ETF, DBO 10-Year backtested performance 2009 through 2019.

Oil ETF, DBO 10-Year backtested performance from 2009 through 2019.

That’s why many crude oil trading strategies are designed differently to avoid those periods by switching between oil and other assets based on market data and trends. By incorporating technical indicators like price action, momentum, and production volume, savvy traders attempt to navigate potential oil price fluctuations. They also often use futures contracts and other derivatives to maintain their trades in changing market conditions.

But building your own algorithmic trading strategy isn’t always easy, especially for beginners. Here is how we think about the process at Composer.

How to Build A Crude Oil Trading Strategy

1. Select your oil investment

As previously discussed, investors have various options across trading platforms when trading oil. You can buy shares in oil production companies, energy exploration partnerships, trade futures contracts, and more. We like oil-backed exchange-traded funds (ETFs) because they are highly liquid and easy to trade, simplifying assembling a strategy that tracks oil prices. Many oil ETFs invest in crude oil futures contracts, enabling traders to build trades incorporating several approaches to energy commodities.

2. Choose your “risk-off” assets

A complete oil trading strategy needs to invest in alternatives when market signals or price trends show oil is out of favor. What will you invest in if you aren’t long (invested in) oil? Naturally, this list can include equities, bonds, and other commodities. We like a blend of gold, Treasury Inflation-Protects Securities (TIPs), and Medium-Term Treasuries since this group tends to be less volatile than oil, provides income, and responds to inflation.

3. Determine your decision criteria

How will you decide when to buy or sell a given investment? Again, there are several options. Basing your strategy around fundamental analysis will involve focusing on supply and demand in the oil market and other macroeconomic factors and forecasts. What is OPEC doing to the supply and, as a result, prices? What does a strong US dollar (USD) mean for the market as a whole? On the other hand, technical analysis is focused more on trends within the oil market. Which way are prices and moving averages trending? Where are the areas of support? We prefer technical analysis because it allows us to quickly incorporate new information into our strategies and make decisions based on objective data related to oil, not hypotheses about economic forces.

4. Think about risk management

How much money will you invest in this strategy? What has the historical volatility and drawdown of the strategy been? How often will your strategy trade, and are there additional risks from day trading? Stop-loss orders are no substitute for evaluating the risks of a strategy and its impact on the total portfolio. Just like with stock trading, thinking about what might go wrong is essential in setting the right expectations for potential gains and losses.

Crude Oil Trading with Composer

Composer's Smarter Oil playbook, an algorithmic trading strategy for oil ETFs.

Composer's Crude Reality: The Smarter Oil Playbook, an algorithmic trading strategy using ETFs.

One example of this process in action can be seen in Composer’s Crude Reality: The Smarter Oil Strategy Playbook, our crude oil-focused trading strategy. It takes advantage of the flexibility of oil ETFs to adapt to fluctuations in the oil market — holding oil futures ETFs when crude oil prices have been doing well and switching to lower-risk assets like gold and medium-term treasury bonds when oil prices are struggling. It’s designed to be the best of both worlds.

Start a free trial with Composer to try simplified algorithmic investing today.

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