Gasoline/Crude Oil Spread: Change the Entry Parameters

The IMC blog is currently working a hypothetical order to short the October RBOB gasoline/crude oil spread on a two-day close below the rising 75-day Moving Average. This could happen today since the spread closed below the 75-day MA yesterday for the first time since late January. Given the fact that the RBOB gasoline/crude oil ratio has been above 1.4:1 for a record duration, we expect the bearish trend change to cause a fast and potentially violent decline.

October Gasoline Crude Oil spread daily

October Gasoline Crude Oil spread daily

The problem, however, is that the spread has dropped nearly eight dollars from the high it posted two weeks ago. This wiped out more than half of the entire advance from the January low to the August high. It means that a short sale near the current price level with a risk to new highs would be a risk of more than eight dollars. To even get a reward-to-risk expectation of 2:1 the spread would have to invert and price gasoline nearly three dollars below the price of crude oil! That’s only happened once in history and it’s certainly a low-probability bet.

Furthermore, while the spread is crashing below the 75-day MA the ratio is just now approaching it. This last two times the ratio pulled back to the 75-day MA was in April and June. Both times, it rebounded and soared to new highs. Until the ratio makes a two-day close below the 75-day MA we have to view it as a test of support and a good chance that a bounce could materialize.

October Gasoline Crude Oil ratio daily

October Gasoline Crude Oil ratio daily

In light of the current circumstances, it makes sense to cancel the short sale below the 75-day MA and look to sell short on a bounce instead. A rebound to somewhere around the Fibonacci .618 retracement of the current decline would be an ideal target to short on a bounce. If the spread can at least make a minimum bounce to the Fibonacci .382 resistance line we can also work orders to sell on a break to new corrective lows and risk above the high of the bounce. Therefore, we are going to adjust the strategy.

As a note of interest, we are currently experiencing only the second time in the last decade when gasoline at the pump is above $2-per-gallon while crude oil is priced below $40-per-barrel. With the futures ratio just coming off of record highs, everything is in place for a major decline. In the event that we actually do see gasoline spill below the price of crude, you can bet that we will be looking for a major buying opportunity!

Trade Strategy:

Cancel the current hypothetical order to short the October RBOB gasoline/crude oil spread on a two-day close below the rising 75-day MA. Work a new contingency to sell one 42,000 gallon October RBOB gasoline contract and simultaneously buy one 1,000 barrel October crude oil contract if the spread rallies to $17-per-barrel. If filled, liquidate on a two-consecutive day close above $21.80.

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