Trading Strategy For Tankers

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Trading strategies in the market for tankers

Amir H. Alizadeh a;Nikos K. Nomikos a
a
Faculty of Finance, Cass Business School, London, UK
To cite this Article Alizadeh, Amir H. andNomikos, Nikos K.(2006) 'Trading strategies in the market for tankers', Maritime
Policy & Management, 33: 2, 119 — 140
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MARIT. POL. MGMT., MAY 2006
VOL. 33, NO. 2, 119–140
Trading strategies in the market for tankers
AMIR H. ALIZADEH* and NIKOS K. NOMIKOS

Faculty of Finance, Cass Business School, London, UK
This paper introduces a new approach in timing the sale and purchase of ships
in the tanker market and examines the performance of this trading strategy over
the period January 1976 to September 2004. Based on the long-run cointegration
relationship between earnings and price, we establish a trading model which
can be used as an indicator of investment or divestment timing decisions. We also
perform statistical tests using the bootstrap approach in order to discount the
possibility of data snooping biases and test the robustness of our trading
Downloaded By: [World Maritime University] At: 11:25 22 April 2010
models. Our results indicate that trading strategies based on earning-price

ratios significantly out-perform buy and hold strategies in the tanker market.
1. Introduction
Investors in shipping markets have always been faced with important and difficult
decisions on investment and divestment timing because of the complex and volatile
nature of the shipping industry. Volatility in the market creates the opportunity for
large profits from speculation on ship prices but at the same time it can also lead to
large losses if investment strategies are implemented at the wrong phase of the cycle.
In competitive and cyclical markets, like shipping, timing is in fact everything.
Therefore, the formulation of sound investment timing strategies is essential and
can make the difference between success and failure in investment decisions. The
fundamental rule of shipping investment is to ‘buy low and sell high’. In other words
to invest in the market at the bottom of the cycle and sell at the peak of the cycle,
when the market has recovered substantially from its previous low, thus leaving
you with a profit. Still however, there are no guarantees about the success of such
strategies since the time horizon of the—always much awaited—revival of the
markets remains uncertain under the influence of a multitude of factors, often
exogenous to the shipping market; see as well Thanopoulou [1] for a discussion
on investment timing strategies in shipping.
Within this setting, the investment analysis of the tanker freight markets presents
a special interest. Crude oil is one of the major commodities transported by sea
and is, perhaps, the most important physical commodity. The primary crude oil
distillates, gasoline, aviation fuel, heating oil and fuel oil are indispensable for
transportation, industrial and residential uses. Seaborne trade in crude oil has grown
enormously over the last five decades during which new sources of supply have been
discovered in the Middle East, West Africa, the US Gulf and the North Sea.
Currently, the world tanker fleet consists of around 3,500 vessels of 10,000 dwt or
more all engaged in activities related to the extraction, storage and distribution of
both crude oil and its refined products. One might assume that this level of activity
*To whom correspondence should be addressed. e-mail: a.alizadeh@city.ac.uk
Maritime Policy & Management ISSN 0308–8839 print/ISSN 1464–5254 online ß 2006 Taylor & Francis
http://www.tandf.co.uk/journals
DOI: 10.1080/03088830600612799
120 A. H. Alizadeh and N. K. Nomikos
has been reached by a steady continuous expansion of the industry but this is far
from the case. In fact, the 1990s can be viewed as the decade of ‘recovery’ of the
industry from the shocks that affected it in the early 1970s and which led to a record
deadweight tonnage capacity by the early 1980s (see also Glen and Martin [2] for an
overview of the tanker market); this by itself indicates the need for a sound and
rational decision making framework in the tanker industry.
In the shipping economics literature, the issue of price formation and volatility
in the shipping markets has been the focus of many empirical studies. Traditional
approaches for modelling ship prices are mainly based on the interaction between
supply and demand factors, using variables such as order book, new building
deliveries, scrapping rate, freight rates, bunker prices, etc. (see 3–5 among others).
Modern techniques, such as real options valuation, are also becoming popular
among analysts (see 6–8 among others).
The issue of price formation in the second-hand market for ships has also been
investigated thoroughly by researchers in their quest to determine whether markets
for ships are efficient and whether ship prices in general are formed rationally.
In fact, it has been argued that if prices for vessels are found to deviate consistently
from their rational or fundamental value (which is the discounted present value
of the future earnings), then trading strategies can be developed to exploit excess
profit-making opportunities; see for instance [9–11]. For example, when ship prices
are lower than their fundamental values, then buying and operating these vessels
may be profitable since they are under-priced in comparison to their future
profitability (i.e. the earnings from freight operations). On the other hand,
when prices are higher than their corresponding rational values, it may be profitable
to charter-in vessels, rather than buying them, since they are overpriced in
comparison to their expected future profitability.
One line of research that so far has received little attention by researchers is
whether sale and purchase decisions of merchant ships, based on fundamental and/or
technical analysis, can be profitable. For example, Adland [12] and Adland and
Koekebakker [13] use technical analysis-based trading rules and argue that if the
market for ships is efficient then trading strategies based on these rules should not
produce wealth in excess of what can be gained through simple buy and hold
strategies [14]. Using both in- and out-of-sample tests, they report that, in general,
trading rules do not yield excess returns that can compensate for transaction and/or
liquidity costs. Although their study seems to provide support for the efficient
market hypothesis (EMH), given the nature of technical analysis, there may be two
points that could be raised. First, as they point out, their results might be dependent
on the variables and set of rules used for constructing the technical trading strategies.
Second, the use of technical trading rules on their own, and not in conjunction with
the underlying economic theory, may not be appropriate. This is because the
historical pattern of the underlying series alone may not be enough to extract
information on the future behaviour of the variable especially if the underlying
variable follows a random walk process.
Therefore, in this study we overcome these shortcomings by developing a
theoretical economic framework which links prices and earnings and then utilizing
such a relationship through technical rules to extract information from the market
for investment purposes. In other words, we do not rely only on the past price
behaviour for trading strategies, but we combine fundamental and technical analysis
by using the co-integration relationship between prices and earnings. In particular,
Trading strategies in the market for tankers 121
we use different functions of the price-earnings (P/E) ratio as indicators of

investment or divestment timing decisions in the dry bulk shipping sector. The
motivation for this stems from the importance of economic indicators and, in
particular, the price-earnings P/E ratio, in predicting asset returns in financial
markets [21]. For instance, P/E ratios of individual stocks or portfolios are regularly
used to explain the returns in the stock market and a number of studies document the
ability of P/E ratios to predict future returns of individual stocks or portfolios.
For instance, Campbell and Shiller [16] show P/E ratios are negatively correlated
with subsequent stock returns over a 10-year period. Other studies on the
information content of P/E ratio in predicting stock returns include Fama and
French [17], Fuller et al. [18], Jaffe et al. [19], and Roll [20].
Therefore, the aim of this paper is to investigate the performance of trading
strategies based on signals provided by fundamental market price indicators such as
the P/E ratio. We consider ships as real capital assets which not only can generate
income through operation but also capital gain (loose) through price appreciation
(depreciation). In this setting we examine whether the P/E ratio can be used to
identify the optimal time to buy or sell second-hand vessels. The profitability
and risk-return characteristics of our proposed strategies are compared with a
simple benchmark strategy, the buy-and-hold strategy, where one invests in the
shipping market all the time. This comparison enables us to assess whether
the dynamic investment strategy, that invest in ships most of the time but switches
to risk-free investments in t-bills when the P/E ratio is too high, is superior to
‘static’ trading strategies. As a matter of fact, if information contained in the P/E
ratio is economically important, one would expect the dynamic strategies to have
higher risk-adjusted returns. Finally, in order to discount the possibility of data
snooping bias, we test the robustness of our trading strategies using bootstrap
simulations.
The findings of this paper have important implications and can be of interest to
investors in shipping markets regarding the timing of investment and divestment.
In addition, recent developments in the areas of shipping investment and finance,
such as the development of shipping funds and derivative contracts for ship values,
may enable participants not only to invest in ships as an alternative investment but
also to speculate on the future outlook of the market without incurring the high costs
of owning or buying a ship.
The structure of this paper is as follows. Section 2 presents the theoretical
background and the methodologies proposed in the asset pricing literature, which
are used to relate prices and earnings for second-hand ships. Section 3 presents the
technical trading strategies that are employed in the paper. The data and their
properties are discussed in section 4. Section 5 presents the empirical results and
section 6 reports the performance of the proposed trading strategies. The discussion
on the implications of the results and the conclusions are presented in the last
section.
2. The theoretical relationship between price and earnings

The incentives for investors in the tanker market are income from the day-to-day
operation of ships as well as gains from capital appreciation in the value of the
vessels. This means that investors will see expected returns on shipping investments,
EtRtþ1, as the sum of capital gains, (EtPtþ1 Pt)/Pt, over the holding period (one in
this case) plus the expected return from operation, Ettþ1/Pt, where EtPtþ1 is the
expected ship price at time t þ 1 and Ettþ1 is the expected operating profit between
period t and t þ 1. Mathematically,

Et Ptþ1 Pt þ Et tþ1
Et Rtþ1 ¼ ð1Þ
Pt
Equation (1) can be rearranged to represent the present value relationship, where
the current ship price, Pt, is expressed in terms of the expected price of the vessel,
expected operational profits and expected rate of return, in the following expression.

Et Ptþ1 þ Et tþ1
Pt ¼ ð2Þ
1 þ Et Rtþ1
Equation (2) is, in fact, a one period present value model; through recursive
substitution and some algebraic manipulation, Pt can be written as the sum of the
present values of the future profits plus the terminal or resale value, Psctþn of the asset.
Mathematically
Xn
i 1 n 1
Pt ¼ ð1 þ E R
t tþj Þ E
t tþ1þi þ ð1 þ E R
t tþj Þ Et Psc
tþn ð3Þ
j¼1 j¼1
i¼1
Equation (2) can also be written in logarithmic form, as shown below, where
pt ¼ lnðPt Þ and t ¼ lnðt Þ (see Appendix A for details).
X
n1 X
n1
pt ¼ i ð1 ÞEt tþ1þi i Et rtþ1þi þ n Et psc n
tþn þ kð1 Þ=ð1 Þ ð4Þ
i¼0 i¼0
Subtracting t from both sides of equation (4), and using some algebraic
rearrangement, the relationship between log time-charter rates and log prices can
be written as:
X
n1
pt t ¼ i ðEt tþ1þi Et rtþ1þi Þ þ n ðEt psc n
tþn Et tþn Þ þ kð1 Þ=ð1 Þ ð5Þ
i¼0
According to Campbell and Shiller [21], the left-hand side of equation (5) is
the actual spread between log ship prices and log time-charter earnings, and the
right-hand side is the theoretical spread, which is based on the expected values
of earnings, discount rates and resale values of the asset. Under efficient market
conditions, the two spread series should be statistically equal with similar volatility,
which can be tested empirically (see [22]).
This model also suggests that the difference between the actual and theoretical
spreads contains information regarding the behaviour of ship prices and
consequently can be used for developing trading strategies and investment decisions.
For example, instances when the actual spread is greater than the theoretical one, can
be interpreted as occasions when actual (or market) ship prices are above the
theoretical ship prices (i.e. the discounted present value of future earnings), which
in turn means that vessels are overpriced relative to their future profits potential.
Therefore, the above model suggests that the spread between ship prices and earnings
(P/E spread or P/E ratio) contains important information regarding investment

timing and trading strategies in shipping markets.
The information content of the earnings and price relationship in the price
formation process can also be viewed through the Granger representation theorem,
which postulates that if two variables are co-integrated (in this case ship prices and
earnings) then at least one variable should Granger cause the other. Furthermore,
as earnings are determined exogenously through the interaction between the
supply and demand for shipping services, which are in turn determined by the
general conditions in the world economy, one would expect the causality to be
unidirectional; that is, from earnings to ship prices and not the other way round.
If this is the case, then changes in operational earnings should affect the log PE ratio
and result in a change in ship price in the next period.
In order to test the co-integrating relationship between second-hand prices and
operational earnings, we use the Johansen’s [23] reduced rank co-integration
technique and estimate the following vector error correction model (VECM).
X
q X
q
pt ¼ a1,0 þ a1,i pti þ b1,i ti þ 1 ðpt1 t1 0 Þ þ "1,t
i¼1 i¼1
Xq Xq
t ¼ a2,0 þ a2,i pti þ b2, iti þ 2 ðpt1 t1 0 Þ þ "2,t ð6Þ
i¼1 i¼1
The above VECM model can be used to establish the co-integrating relationship
between log prices and log earnings which underpins the linkage and co-movement
of ship prices and earnings. The important element of the co-integration relationship
is the error correction term (ECT) which can be regarded as the spread between
log prices and log earnings (pt1 t1 0 ). In particular, the constant term in the
error correction term, 0, represents the long run equilibrium relationship or the
average of the P/E ratio.
3. Constructing a trading strategy

Having established the existence of a long-run equilibrium relationship between ship
prices and earnings, we then proceed to develop a trading strategy that utilizes this
relationship to identify investment timing opportunities. As mentioned earlier,
the price of a vessel is linked to her expected operational earnings which are, in turn,
determined by current and expected conditions in the oil markets, the international
trade in petroleum and petroleum products as well as conditions in the world
economy. This theoretical relationship between prices and earnings enables us to
utilise the historical correlation and co-integration between these two stochastic
variables as indicators of market movements and, consequently, as signals for buying
and/or selling decisions.
In practice, one can devise limitless trading rules and strategies, as there are
multiple combinations of relationships between variables that can produce a trading
signal as well as multiple parameterizations for a given family of rules. For instance,
there are different combinations of moving average (MA) rules reflecting different
time spans in the estimation of MA prices; similarly, there are numerous
parameterizations of filter rules, depending on how many standard deviations one
allows before reversing a position. As it is beyond the scope of this study to evaluate
an exhaustive set of trading rules, we focus our efforts on two simple cases of MA
rules based on the relationship between ship prices and earnings.
Moving average trading strategies are based on the comparison of one fas- (short)
and one slow- (long) moving average of the ratio of log-earnings to log-prices. For
example, one such strategy is to compare a 12-month MA of the log-price to log
earnings ratio with a 1-month MA of the same series. In this setting, in any given
month, a positive difference between the 12-month MA and the 1-month MA of the
logarithmic ratio signals a buy decision. This is because when the 12-month MA is
greater than the 1-month MA this can be interpreted as the series being below its
long-run average (which is represented by the 12-month MA). Consequently, this
implies that the ratio of log prices to log earnings is lower than its long run average
or, alternatively, that ship prices are undervalued relative to their earnings potential
and, hence, ship prices are likely to increase over the coming period. Similarly,
a negative difference signals a sell decision as it is an indication that earnings are low
relative to ship prices or in other words, ship prices are overvalued relative to their
earnings potential. Under such circumstances, ship prices in the market are expected
to adjust in future periods, i.e. prices are likely to decline and hence it is appropriate
for investors to sell in the market [24].
4. Description of data
The tanker market is segmented into fours major sub-sectors, due to the
transportation needs in the oil industry as well as the physical characteristics of
the routes and ports that such vessels serve. The types of vessels operating in this
market are: very large crude carriers (VLCC, 160,000 dwt and over); Suezmax
(80,000 to 160,000 dwt); Aframax (40,000 to 80,000 dwt); and Handysize (20,000
to 40,000 dwt). The two larger size tankers are involved in crude oil transportation.
Aframax vessels are also involved in transportation of crude oil, however, they
primarily contribute to oil product transportation. Handysize tankers are mainly
engaged in the transportation of oil products [25], although they can also be
employed in short-haul crude oil transportation at times. The employment of
Handysize tankers in clean product transportation is mainly due to the small parcel
size of petroleum products, which rarely exceed 60,000 tons.
Due to the limited number of petroleum export and import areas around the
world, as well as draught and capacity restrictions in certain oil terminals, ports and
canals, operation of larger tankers is restricted to certain routes. For instance, the
maximum size of a loaded tanker that can go through the Suez Canal is about
160,000 dwt. The three major routes for VLCCs are from the Persian Gulf to (i) the
Far East, (ii) North America and (iii) north-west Europe via the Cape. Suezmax
tankers are mainly operating between the Persian Gulf and north-west Europe
through the Suez Canal, as well as West Africa to the US Gulf and the US East
Coast. The major routes for Aframax tankers are from West Africa and North Sea
to US East Coast, from North Africa to the Mediterranean and north Europe, and
from the Persian Gulf to the Far East. Handysize tankers are mainly employed in
regional (US Gulf–US East Coast, Persian Gulf, west Europe and the Far East) dirty
product transportation, however, they occasionally serve long-haul routes such as
the Middle East to the Far East and Europe.
For the purposes of this study, monthly prices for five-year-old tankers are
collected for three different size classes, namely, VLCC, Aframax and Handysize,
from Clarkson’s Shipping Intelligence Network, from January 1976 to September

2004 [26]. All prices are quoted in million dollars and represent the average value
of vessels sold in each category in any particular month.
In shipping, operating earnings can be derived from time-charter rates, or the
time-charter equivalent of spot rates, when a vessel is operating in the spot market.
In this study, we use time-charter rates as a proxy for earnings, t, when we set up
the trading model for two reasons. However, in calculating returns on shipping
investment, we use spot earnings instead of time-charter earnings as these earnings
are more representative of what actually a tanker operator generates. We use
time-charter earnings to construct price–earnings (P/E) ratio because time-charter
rates do not include voyage costs, they represent the net earnings from the chartering
activities of the vessel. In addition, since time-charter rates are hire contracts for
a number of consecutive periods, they are considered to contain information about
future earnings of the vessel during these periods (see [22] for a detailed discussion
of time-charter rates formation). As a result, it is believed that time-charter
rates (earnings) may explain price changes better than current spot rates. Monthly
time-charter rates and spot earnings for Handysize, Aframax and VLCC tankers
over the period January 1976 to September 2004 are also obtained from Clarkson’s
Shipping Intelligence Network.
Table 1 reports descriptive statistics of levels and logarithmic first differences
of second-hand prices, as well as time-charter earnings for different size tankers.
The results indicate that mean levels of prices for larger vessels are higher than
smaller ones. Unconditional volatilities of prices (standard deviations) also follow
a similar pattern; that is, prices for larger vessels fluctuate more than prices for
smaller vessels. Jarque and Bera [27] tests indicate significant departures from
normality for TC earnings and price returns in all markets, while price levels for
all size classes seem to be normally distributed. The Ljung and Box [28] Q statistics
for 12th order autocorrelations in levels and logarithmic first differences of earnings
are all significant, indicating that serial correlation is present in all price and profit
series. Finally, Engle’s [29] ARCH tests for 12th order ARCH effects indicate the
existence of autoregressive conditional heteroscedasticty in all series.
Phillips and Perron [30] (PP) unit root tests are performed on the log-levels and
log-differences of second-hand prices and time-charter rates (earnings), for the three
size tanker ships. PP results, reported in table 2, suggest that log-levels of all price
and earnings series are non-stationary, while their first differences are stationary,
indicating that variables are integrated of order one, I(1). Also, PP unit root tests on
spreads between logs of second-hand prices and time-charter rates for different size
tankers indicate that all spread series are stationary. Studies in the literature argue
that PP tests may have low power in rejecting the unit root null hypothesis in favour
of the alternative of stationarity (see Harris [31] and Maddala and Kim [32].
Lee et al. [33] suggest that one way of overcoming this problem is by conducting
unit root tests which test the null of stationarity against the alternative of a unit root,
such as the test developed by Kwiatkowski et al. [34], henceforth KPSS test. In the
KPSS test, the null hypothesis of stationarity is rejected in favour of the unit root
alternative, if the calculated test statistic exceeds the corresponding critical values.
KPSS test results, in table 2, confirm that the log price and time-charter earnings
series are non- stationary, I(1), while the spreads between prices and time-charter
earnings are in fact stationary. These results also provide early evidence that log
Table 1. Summary statistics of price (P) and TC earnings (TC) for different size tankers.
Mean SD J-B Q(12) ARCH(12)
Handysize
Second-hand prices, P ($m) 15.744 5.201 7.733 2500 296.2
{0.021} {0.000} {0.000}
1 year TC earnings, ($m) 3.583 1.127 5.340 2485 318.24
{0.069} {0.000} {0.000}
Log return p (%) 0.054 0.202 566.2 12.517 15.410
{0.000} {0.405} {0.220}
Log change (%) 0.045 0.149 657.1 105.3 18.793
{0.000} {0.000} {0.094}
Aframax
{0.000} {0.000} {0.000}
{0.029} {0.000} {0.000}
Log return p (%) 0.059 0.166 119.2 92.25 25.25

{0.000} {0.000} {0.014}
Log change (%) 0.061 0.284 968.8 36.985 54.36
{0.000} {0.000} {0.000}
VLCC
{0.000} {0.000} {0.000}
{0.000} {0.000} {0.000}
Log return p (%) 0.074 0.221 1680 82.89 46.83
{0.000} {0.000} {0.000}
Log change (%) 0.075 0.297 887.1 21.37 9.596
{0.000} {0.045} {0.651}
. Sample period is January 1976 to September 2004.

. Figures in {} are p-values.
. Returns and Standard Deviations (SD) of returns are annualized.
. Skew and Kurt are the estimated centralized third and fourth moments of the data, pffiffiffiffi denoted ^ 3 and
(^ffiffiffi
p 4 ffi 3), respectively. Their asymptotic distributions, under the null, are T ^ 3 N(0,6) and
Tð^ 4 3Þ Nð0, 24Þ.
. J-B is the Jarque–Bera [27] test statistics for normality; it is 2(2) distributed.
. Q(12) is the Ljung–Box ([28] Q statistic on the 12th order sample autocorrelations of the raw series,
distributed as 2(12).
. ARCH(12) is the Engle’s [29] test for 12th order ARCH effect; the statistic has a 2(12) distribution.
prices and time-charter earnings are co-integrated, and render support for the use
of the VECM specification for modelling ship price changes.
Finally, figure 1 to figure 3 plot the second-hand prices along with one-year time-
charter rates for the three size tankers over the sample period. It can be seen that
while prices and time-charter rates move together in the long run, they tend to vary
over time and under different market conditions. In addition, comparison of
behaviour of prices across different vessel sizes reveals that prices for all three
categories of tankers tend to move close together over the long run, while their short-
run behaviour seems to be different and show idiosyncratic stochastic behaviour over
time. Different short-term dynamics of different size ship prices might be related
to differences in the supply and demand for each type vessel and the prevailing
conditions in the shipping industry.
Table 2. Phillips–Perron and KPSS unit root tests of logs of prices (p), log time-charter (p),
and of the spread series (p-p).
Handysize Aframax VLCC
Variables Log – level Log – diff Log – level Log – diff Log – level Log – diff
Philips–Perron test
p 2.154a 16.174b* 1.120a 12.750b* 1.262a 17.021b*
2.094a 12.696b* 1.924a 14.878b* 1.149a 16.225b*
KPSS test
p 1.415a* 0.074a 1.803b* 0.044b 1.594b* 0.062b
0.910b* 0.050b 1.606b* 0.045b 2.011b* 0.034b

. The lag length for each test is chosen using the Newey–West [28] bandwidth selection.
. * indicates significance at the 1% level.
. Phillips–Perron (PP) [30] tests test the null hypothesis that the variable is non stationary, I(1), against
the alternative that the variable is stationary, I(0). The 1%, 5% and 10% critical values for the
Phillips–Perron [30] test with a constant (superscript a) are 3.451, 2.871 and 2.571, respectively. The
1%, 5% and 10% critical values for the Phillips–Perron [30] test without constant and trend (superscript
b) are 2.573, 1.942 and 1.616, respectively.
. Kwiatkowski–Phillips–Schmidt–Shin (KPSS) [34] tests test the null hypothesis that the variable is
stationary, I(0), against the alternative that the variable is non stationary, I(1). The 1%, 5% and 10%
30 20
18
TC rate $/day (thousands)

25 16
14
20
Price ($m)
12
15 10
8
10 6
Price TC rate 4
5
2
0 0
7 01
89 2
9 1
9 2
9 3
9 4
9 5
95 6
9 7
9 8
98 9
9 0
00 1
0 2
0 1
04 2
3
7 2
7 3
8 4
8 5
8 6
8 7
8 8
85 9
8 0
8 1
20 9–1
19 7 – 1
19 – 0
19 0–0
19 1–0
19 2–0
19 3–0
19 4–0
19 –0
1 9 6– 0
19 7 – 0
19 – 1
20 – 1
20 2–0
20 3–0
–0
19 7–0
19 8–0
19 9–0
19 0–0
19 1–0
19 2–0
19 3– 0
19 4–0
19 – 1
1 9 6– 1
–
76
19
19
Figure 1. Historical prices and time-charter rates for Handysize tankers.
5. Empirical results
Once it is established that tanker prices and time-charter earnings are non stationary
I(1) variables, co-integration techniques are used to examine the existence of a long-
run relationship between these series. The lag length (q ¼ 1) in the VECM of
equation (6) is chosen on the basis of the Schwarz Bayesian Information Criterion
(SBIC) [35] as well parameter parsimony of the VECM. LR tests indicate that an
intercept term should be included in the long-run relationship [36]. Johansen’s [23]
60 35

50 30
Price TC rate
25
40
Price ($m)
20
30
15
20
10
10 5
0 0
7 01
8 2
90 1
9 2
9 3
93 4
9 5
95 6
9 7
9 8
98 9
9 0
00 1
0 2
0 1
04 2
3
7 2
7 3
8 4
8 5
8 6
8 7
8 8
8 9
8 0
8 1
2 0 9–1
19 7–1
19 9 – 0
19 –0
1 9 1–0
19 2 – 0
19 –0
19 4–0
1 9 –0
19 6–0
19 7–0
19 –1
20 – 1
20 2–0
20 3–0
–0
19 7–0
19 8–0
19 9–0
19 0–0
19 1–0
19 2–0
19 3–0
19 4–0
1 9 5–1
19 6–1
–
76
19
19
Figure 2. Historical prices and time-charter rates for Aframax tankers.

100 60

90
80 Price TC rate 50
70 40
Price ($m)
60
50 30
40
30 20
20 10
10
0 0
7 01
8 2
90 1
9 2
9 3
93 4
9 5
95 6
9 7
9 8
98 9
9 0
00 1
0 2
0 1
04 2
3
7 2
7 3
8 4
8 5
8 6
8 7
8 8
85 9
8 0
8 1
20 9–1
19 7–1
19 9–0
19 –0
19 1–0
19 2–0
19 –0
19 4–0
19 –0
19 6–0
19 7–0
19 –1
20 –1
20 2–0
20 3–0
–0
19 7–0
19 8–0
19 9–0
19 0–0
19 1–0
19 2–0
19 3–0
19 4–0
19 – 1
19 6–1
–
76
19
19
Figure 3. Historical prices and time-charter rates for VLCC tankers.
reduced rank co-integration method is then used to establish the co-integration

relationship between ship prices and earnings. This method involves assessing the
rank of the long-run coefficients matrix, , through the max and trace statistics. The
rank of in turn determines the number of co-integrating relationships; for instance
if rank () ¼ 1 then there is a single co-integrating vector describing the long-run
equilibrium relationship between the variables. In this case, can be factored as
¼ 0 , where and are 2 1 vectors [37]. Using this factorization, 0 , represents
the vector of co-integrating parameters and is the vector of error correction

coefficients measuring the speed of convergence to the long-run steady state. Results
from these tests are reported in table 3. The max and trace statistics indicate the
existence of one co-integrating vector between tanker prices and TC earnings in each
market, although the evidence for the VLCC market seems to be a little weaker than
the Handysize and Aframax markets. This means that log prices and TC earnings are
linked through a unique long-run relationship and any deviation from this
equilibrium is restored through the short-term adjustment of these variables.
The estimated co-integrating vectors, i.e. [1 0] from equation (6), are also
presented in the same table. These unrestricted co-integrating vectors are used in the
estimation of the VECM model which are presented in table 4. Residual diagnostics
indicate that autocorrelation and heteroscedasticty are present in the residuals of
all the regressions. Consequently a Newey-West [38] correction for serial correlation
and heteroskedasticity is applied to the standard errors of the regressions.
Examination of the vector of error correction coefficients, , provides insight into
the adjustment process of the different variables towards equilibrium. Consider first,
the system of equations for Aframax and VLCC markets. Significance of the error
correction terms ( 1 and 2) in both price and earnings equations in these markets
indicates that price and TC earnings tend to converge to their log long-run
relationship. For instance, in response to a positive deviation from their long-run
relationship at period t 1, i.e. when pt1 t1 0 > 0, ship prices decrease and
earnings will increase the following period, thus restoring equilibrium in the market.
The same pattern is evident in the Handysize markets with the exception that in this
market only ship prices tend to respond to any long-run disequilibrium.
The interaction between the price and TC earnings is also investigated through
Granger causality tests. We test such causality between the variables by imposing
the appropriate restrictions on the VECM model. The results of these tests are also
presented in the table 4. According to the Granger [39] representation theorem,
if two price series are co-integrated, then causality must exist in at least one direction.
Theoretically, one would expect that operational earnings to Granger cause ship
prices. Tests for the joint significance of the lagged cross-market returns and error
correction coefficients, confirm the conjecture that TC earnings Granger cause ship
prices. However, ship prices also Granger cause TC earnings in the VLCC and
Aframax markets, while in the Handysize market there is no evidence of such
causality at the 1% level. This finding implies that causality in the VLCC and
Aframax markets is bilateral and in a form of feedback from prices to earnings.
6. Performance of MA trading rules

The trading strategy proposed in this paper, which combines the fundamental
relationship between variables with technical trading rules, is based on the deviation
of the ratio of log price and log TC earnings from its long run mean. In order to
determine the timing of sale and purchase, we devise two MA series using ration of
log price and log TC rates, one slow [e.g. MA(12) or MA(6)] and one fast [MA(1)],
as shown in figure 4 for the Aframax market. The difference between the two
constructed MA series is then used as an indicator which signals for buy and sells
signals in the second-hand market, as shown in figure 5. The signals based on the
sign of the difference between the slow and fast MA in such a way that a positive
difference is sell signal, while a negative difference is a buy signal. If investment rule
130
Table 3. Johansen’s co-integration tests of log-prices (p) and log time-charter earnings (p).
q
X q
X
i¼1 i¼1
Xq Xq
t ¼ a2,0 þ a2,i pti þ b2, iti þ 2 ðpt1 t1 0 Þ þ "2,t
i¼1 i¼1
max trace
max max trace trace Normalized
Pair of variables Lags H0 HA 95% CV’s H0 HA 95% CV’s coin vector
Handysize [1 0]
lnP and ln q¼1 r ¼0 r 1 19.38 12.29 r¼0 r¼1 19.38 13.43 [1 0.991 1.483]
r1 r ¼2 2.59 2.71 r1 r¼2 2.59 2.71
Aframax
lnP and ln q¼1 r¼0 r1 24.51 12.29 r¼0 r¼1 26.53 13.43 [1 1.113 1.498]
r1 r ¼2 2.02 2.71 r 1 r¼2 2.02 2.71
VLCC
lnP and ln q¼1 r ¼0 r 1 12.80 12.29 r¼0 r¼1 13.30 13.43 [1 1.265 1.315]
r 1 r ¼2 0.49 2.71 r1 r¼2 0.493 2.71
A. H. Alizadeh and N. K. Nomikos

. Johansen’s [23] and [42] reduced rank co-integration tests for each pair are estimated using a model with a constant in the cointegrating vector and no trend.
. The appropriate number of lags in each case is chosen by minimizing SBIC.
. max ðr,r þ 1ÞP¼ T lnð1 ^rþ1 Þ tests the null hypothesis of r co-integrating vectors against the alternative of r þ 1.
. trace ¼ T ni¼rþ1 lnð1 î Þ tests the null that there are at most r co-integrating vectors against the alternative that the number of co-integrating vectors is greater than r,
where n is the number of variables in the system (n ¼ 2 in this case).
. CV’s represent critical values from Osterwald-Lenum [43].
Table 4. Result of VECM for three size ships.
X
q X
q
i¼1 i¼1
Xq Xq
t ¼ a2,0 þ a2,i pti þ b2, iti þ 2 ðpt1 t1 0 Þ þ "2,t
i¼1 i¼1
Estimated model for:
pt t pt t pt t
i I ¼ 1,2 0.067 0.010 0.034 0.069 0.022 0.038

(0.016) (0.011) 0.010 (0.019) (0.009) (0.013)
[4.133] [0.846] [3.250] [3.613] [2.292] [2.873]
pt1 0.133 0.002 0.358 0.238 0.198 0.145

(0.054) (0.038) (0.049) (0.089) (0.053) (0.071)
[2.491] [0.048] [7.362] [2.672] [3.759] [2.037]
t1 0.022 0.370 0.081 0.244 0.054 0.152
(0.074) (0.052) (0.029) (0.054) (0.040) (0.054)
[0.295] [7.025] [2.796] [4.559] [1.348] [2.832]
Constant 0.004 0.002 0.003 0.003 0.004 0.004
(0.003) (0.002) (0.002) (0.004) (0.003) (0.004)
[1.243] [1.034] [1.259] [0.667] [1.287] [0.952]
R 2 0.059 0.125 0.200 0.089 0.050 0.043
Causality test Statistics p-value DF Statistics p-value DF Statistics p-value DF
t ! pt 4.580 {0.011} 2 7.538 {0.001} 2 4.011 {0.019} 2
pt ! t 0.190 {0.827} 2 5.586 {0.004} 2 4.481 {0.012} 2

. Standard errors, in (), are corrected for serial correlation and/or heteroscedasticity using the
Newey-West [38] method.
. Figures in [] are t-statistics.
indicates an exit position from the shipping market, then it is assumed that funds can
be invested in treasury-bills with fixed returns. We also assume a non-linear monthly
depreciation rate of 1% in the value of vessels which is derived from the difference
between average price of five-year-old and ten-year-old tankers. The transaction
cost of 0.5% is assumed also for every sale and purchase positions.
The outlined MA trading model is applied to each sub-market within the tanker
shipping sector and the results are compared against a benchmark buy-and-hold
strategy where one is always an investor in the shipping markets. The performance of
the different strategies is presented in table 5. It can be noted that all three MA(3, 1),
MA(6, 1) and MA(12, 1) strategies outperform the buy and hold strategy as indicated
by the Sharpe Ratios across all markets. For instance, the average annualized returns
across all markets increased significantly from 17.58%, 16.09% and 14.99% for
Handysize, Aframax and VLCC, respectively, when buy and hold strategy is used
to 22.73%, 21.25% and 23.18% when MA(12, 1) strategy is used. Apart from
significant higher returns, the results of MA trading rules also reveal significant
reductions in the standard deviation of trading rules too, which suggests that a better
performance measure for comparison of trading rules could be the Sharpe ratio
0.8
0.7
0.6
0.5
0.4
0.3
0.2 MA12 MA1
0.1
0
5
2
20 07
20 02
20 09
19 –04
19 06
19 01
19 08
19 03
19 10
19 05
19 12
7
2
9
4
19 –11
19 06
19 –01
19 11
–0
–1
–0
–0
–0
–0
–
–
–
–
–
–
–
–
–
–
–
–
95
04
02
01
00
98
97
78
94
93
91
90
88
87
85
84
83
81
80
77
76
20
19
19
19
19
19
Figure 4. Plot of moving average 12 (MA12) and moving average 1 (MA1) of historical ratio
log price–log earnings in Handysize tanker market.
MA12 DEV
0.20
0.15
0.10
0.05
0
– 0.05
– 0.10
– 0.15
– 0.20
– 0.25
– 0.30
– 0.35
8
7
4
20 05
6
19 01
19 02
19 03
19 04
19 05
19 06
0
9
3
1
1
–1
–0
–0
–0
–0
–0
–0
–1
–0
–1
–0
–0
–0
–
–
94
04
03
00
01
02
84
85
86
87
88
89
90
91
93
92
95
98
99
97
19
20
20
20
20
19
19
19
19
19
19
19
19
Figure 5. Plot of difference of slow and fast MA series on historical ratio of log price–log
earnings in Handysize tanker market.
(the ratio of average return and standard deviation). Not surprisingly, Sharpe
ratios also indicate that MA trading strategies outperform the buy and hold strategy
across all markets. The Sharpe ratios of the buy and hold strategies in Handysize,
Aframax and VLCC markets (0.8217, 0.9397 and 0.6415, respectively) increased
significantly (1.5960, 1.6381 and 1.4332, respectively) when the MA(12, 1) trading
rule is applied.
The cumulative return on MA(12, 1) trading rule and buy and hold investment
strategy in Handysize, Aframax and VLCC markets are shown in figures 6, 7 and 8,
respectively. The significant increase in cumulative returns when active MA(12, 1)
trading rule is employed compared to buy and hold strategy is evident across
Table 5. Result of empirical simulation of trading strategies.

MA12/MA1 on lnE/lnP ratio

Mean return 0.2273 0.2125 0.2318
SD 0.1424 0.1297 0.1618
Sharpe ratio 1.5960 1.6381 1.4332
Mean return 0.2011 0.2027 0.2044
SD 0.1449 0.1313 0.1619
Sharpe ratio 1.3881 1.5446 1.2637
Mean return 0.1879 0.1966 0.1956
SD 0.1569 0.1285 0.1571
Sharpe ratio 1.1978 1.5301 1.2455
Buy and hold
Mean return 0.1758 0.1609 0.1499
SD 0.2139 0.1712 0.2337

Sharpe ratio 0.8217 0.9397 0.6415
. Sample period is January 1976 to September.

. Returns and standard deviations are annualized.
14 000
12 000
Cum Ret MA Cum Ret
10 000
8000
6000
4000
2000
0
2
8
20 04
20 12
20 08
20 04
19 12
19 08
19 04
19 12
8
4
2
8
4
2
8
4
2
8
4
–1
–0
–0
–0
–1
–0
–0
–1
–0
–0
–1
–0
–0
–
–
–
–
–
–
–
–
77
04
03
01
00
99
97
96
95
93
92
91
89
88
87
85
84
83
81
80
79
19
19
19
19
19
19
19
19
19
19
19
19
19
Figure 6. Cumulative return on MA trading strategy for Handysize tanker.
all markets. In fact, it is interesting to note that the trading models based on the ratio
of log price and log earning correctly identify the buy signal during the lucrative
shipping markets of 2003–2004 when earnings increased sharply compared to ship
prices.
It has been argued in the literature that technical trading strategies developed
based on a sample might be prone to data snooping and therefore may not be as
good as they promise to be out of sample or when a new data set is used. Therefore,
it is important to ascertain whether the superior performance of our trading models
based on the ratio of log price and log earnings is a result of superior economic
content or is simply due to luck. To investigate such argument, we test the
30 000
25 000
Cum Ret MA Cum Ret
20 000
15 000
10 000
5000
0
19 12
8
20 04
20 12
20 08
20 04
19 12
19 08
19 04
19 12
19 08
19 04
19 12
19 08
19 04
19 12
19 08
19 04
19 12
19 08
19 04
–0
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
77
04
03
01
00
99
97
96
95
93
92
91
89
88
87
85
84
83
81
80
79
19
Figure 7. Cumulative return on MA trading strategy for Aframax tanker.

25 000
20 000 Cum Ret MA Cum Ret
15 000
10 000
5000
0
19 01
19 06
19 04
19 09
19 02
19 07
19 12
19 05
19 10
19 03
19 08
19 11
19 01
19 06
19 04
5
20 09
20 02
20 07
20 12
19 11
–0
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
78
76
77
80
95
81
83
84
85
87
88
90
91
93
94
97
04
98
00
01
02
19
Figure 8. Cumulative return on MA trading strategy for VLCC tanker.
performance of our trading rules using the bootstrap technique. The bootstrap,
introduced by Efron [40] and Efron and Tibshirani [41], is a data-based simulation
method that uses the empirical distribution of the statistic of interest, rather than the
theoretical distribution implied by statistical theory, to conduct statistical inference.
Its main attraction relies on the fact that it can approximate the sampling
distribution of the estimator of interest even when this is very difficult or impossible
to obtain analytically and only an asymptotic approximation is available.
The bootstrap method used in this study is essentially a resampling technique
which uses the historical returns based on both the buy and hold and the MA trading
strategies to generate new resampled return series. This is achieved by drawing
randomly with replacement a from the buy and hold and MA trading return series a
new sample of returns that have the same size as the original historical returns. Then
for each one of these resampled series, we estimate its mean, standard deviation,
Table 6. Result of bootstrap simulation of trading strategies.

Buy and hold

Mean return 0.1825 0.1748 0.1316
Mean return 0.2269 0.2129 0.2332
Diff. in Sharpe ratio 0.8113 0.6621 0.8807
90% CI of Diff. in Sharpe ratio [0.4512 1.2427] [0.4086 0.8310] [0.5616 1.2139]
Mean return 0.2010 0.2037 0.2055
Diff in Sharpe ratio 0.5937 0.5695 0.7113
90% CI of Diff in Sharpe ratio [0.2655 0.9550] [0.3213 0.8310] [0.4236 1.0406]
Mean return 0.1880 0.1971 0.1964
Diff. in Sharpe ratio 0.3882 0.5548 0.6938
90% CI of Diff. in Sharpe ratio [0.1142 0.7010] [0.2908 0.8188] [0.3819 1.0109]

. Results are based on 1,000 bootstrap simulation of the returns of trading strategies.
. ** indicates that the difference between returns using the MA strategy and the buy and hold strategy
is significance at the 10% level based on the 90% empirical confidence intervals.
Sharpe ratio and difference in Sharpe ratio between buy and hold and MA based
strategies. This procedure is repeated 1,000 times and then distributions for each
one of the statistics of interest are produced.
The results of the bootstrap simulations, including the mean returns, differences in
Sharpe ratios as well as 90% confidence interval for differences in Sharpe ratios for
each market, are reported in table 6. First, it can be observed that the annualized buy
and hold mean returns are more or less similar to the ones observed in the empirical
series under the same trading rule. Also it can be seen that difference in Sharpe ratios
(Sharpe ratio of MA rule minus the Sharpe ratio of buy and hold) are all positive,
which indicates better performance of MA strategies in the bootstrap simulation.
Finally, the 90% confidence interval of difference in Sharpe ratios indicate that all
differences are significantly greater than zero in all markets, which provides support
for the robustness of the superiority of the MA trading strategies compared to buy
and hold benchmark.
Figures 9 to 11 plot the distributions of returns of three MA strategies [MA(12, 1)
and MA(6,1)] against the static trading strategies using the bootstrap technique for
Handysize, Aframax and VLCC markets, respectively. These graphs clearly illustrate
the benefits of using trading signals derived from ship prices and earnings in shipping
investment as the distribution of simulated returns based on MA rules show
significant shifts to the right with relatively lower dispersion. Overall, the bootstrap
simulation analysis confirms the robustness of the timing strategies proposed in this
paper and the fact that the relationship between price and earnings in shipping
markets contains important information about the future behaviour of ship prices.
7. Summary and conclusions

In this study we proposed and tested a new approach for timing investment and
divestment decisions in the tanker markets. In particular, we utilized the relationship
14
BH_Strategy
12
MA6_Strategy
10 MA12_Strategy
0
0 0.05 0.10 0.15 0.20 0.25 0.30 0.35
Figure 9. Bootstrapped distributions of returns of MA trading strategies against buy and hold
in the Handysize market.
15.0
BH_Strategy
12.5
MA6_Strategy
MA12_Strategy
10.0
7.5
5.0
2.5
0
0 0.10 0.15 0.20 0.25 0.30
in the Aframax market.
between price and earning variables in different sectors of the tanker shipping market
and devised strategies to identify the timing for sale and purchase of tankers.
The theoretical relationship between ship prices and TC earnings, based on the
discounted present-value model, is discussed in detail and a co-integration
relationship is established between ship prices and earnings. Using the co-integration
relationship between ship prices and time-charter earnings, we developed a trading
strategy which is based on the deviation of the ratio of log price and log earnings
from its long-run mean. The turning points of this ratio are identified using moving
12
BH_Strategy
10
MA6_Strategy
MA12_Strategy
8
0
– 0.08 0.00 0.08 0.16 0.24 0.32
in the VLCC market.
average trading rules, and used as indicators for buy and sell opportunities. Such
strategies are then applied to historical series which revealed promising results when
compared with static buy and hold strategies. In order to ascertain the robustness,
superiority and consistency of our model, we also used bootstrap techniques to
compare the distribution of returns and Sharpe ratios of active trading models with a
passive buy and hold strategy.
Overall, our results revealed that the relationship between price and earnings in
shipping markets contains important information about future behaviour of ship
prices, which can be used for investment timing in shipping markets. It is also shown
that investors in the tanker market can benefit from combining technical trading
rules with fundamental analysis when making sale and purchase decisions. Finally,
it seems that these trading strategies work better for market for larger vessels (VLCC
and Aframax) than smaller ones (Handysize). This can be attributed to the higher
volatility in the market for larger vessel which provides better opportunities for asset
players to take advantage of investment timing.
Appendix A
Campbell and Shiller [16] suggest that equation (2) can be written in logarithmic
form using a first-order Taylor series expansion and linearzsing (1) around the
geometric means of P and (P and Þ,
respectively to give:
lnð1 þ Et Rtþ1 Þ ¼ lnðEt Ptþ1 Þ þ ð1 Þ lnðEt tþ1 Þ ln Pt þ k ðA:1Þ

where ¼ P=ð P þ Þ and k ¼ lnðÞ ð1 Þ lnð1= 1Þ. Letting Et ptþ1 ¼
lnðEt Ptþ1 Þ, Et rtþ1 ¼ lnð1 þ Et Rtþ1 Þ and Et tþ1 ¼ lnðEt tþ1 Þ, equation (2) can be
written as:
pt ¼ Eptþ1 þ ð1 ÞEtþ1 Ertþ1 þ k ðA:2Þ
which can be solved recursively forward to yield

X
n1 X
n1
pt ¼ i ð1 ÞEt tþ1þi i Et rtþ1þi þ n Et psc n
tþn þ kð1 Þ=ð1 Þ ðA:3Þ
i¼0 i¼0
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Trading Strategy For Tankers

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Trading Strategy For Tankers

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This article was downloaded by: [World Maritime University]

On: 22 April 2010

Maritime Policy & Management

Trading strategies in the market for tankers

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Trading strategies in the market for tankers

AMIR H. ALIZADEH* and NIKOS K. NOMIKOS

models. Our results indicate that trading strategies based on earning-price

*To whom correspondence should be addressed. e-mail: a.alizadeh@city.ac.uk

we use different functions of the price-earnings (P/E) ratio as indicators of

2. The theoretical relationship between price and earnings

(P/E spread or P/E ratio) contains important information regarding investment

3. Constructing a trading strategy

from Clarkson’s Shipping Intelligence Network, from January 1976 to September

Log return p (%) 0.059 0.166 119.2 92.25 25.25

. Sample period is January 1976 to September 2004.

Handysize Aframax VLCC

. Sample period is January 1976 to September 2004.

TC rate $/day (thousands)

Figure 1. Historical prices and time-charter rates for Handysize tankers.

TC rate $/day (thousands)

Figure 2. Historical prices and time-charter rates for Aframax tankers.

TC rate $/day (thousands)

Figure 3. Historical prices and time-charter rates for VLCC tankers.

reduced rank co-integration method is then used to establish the co-integration

the vector of co-integrating parameters and is the vector of error correction

6. Performance of MA trading rules

. Sample period is January 1976 to September 2004.

Table 4. Result of VECM for three size ships.

Estimated model for:

Handysize Aframax VLCC

pt t pt t pt t

i I ¼ 1,2 0.067 0.010 0.034 0.069 0.022 0.038

pt1 0.133 0.002 0.358 0.238 0.198 0.145

. Sample period is January 1976 to September 2004.

Table 5. Result of empirical simulation of trading strategies.

MA12/MA1 on lnE/lnP ratio

SD 0.2139 0.1712 0.2337

. Sample period is January 1976 to September.

Figure 6. Cumulative return on MA trading strategy for Handysize tanker.

Figure 7. Cumulative return on MA trading strategy for Aframax tanker.

20 000 Cum Ret MA Cum Ret

Figure 8. Cumulative return on MA trading strategy for VLCC tanker.

Table 6. Result of bootstrap simulation of trading strategies.

Buy and hold

. Sample period is January 1976 to September 2004.

7. Summary and conclusions

– 0.08 0.00 0.08 0.16 0.24 0.32

lnð1 þ Et Rtþ1 Þ ¼ lnðEt Ptþ1 Þ þ ð1 Þ lnðEt tþ1 Þ ln Pt þ k ðA:1Þ

which can be solved recursively forward to yield

Economics and Business Administration.

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