February 20, 2018 Facebook  twitter  Google+
Trading Crude Oil Correlations
Adam Lemon
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Crude Oil Pitfalls

Crude oil is very, very volatile, much more volatile than Forex currency pairs. For this reason, most brokers enforce a considerably lower maximum true leverage on crude oil trades compared to Forex currency pairs. Even though brokers and regulators are doing a little something to try to save you from blowing up, you still have a lot of work to do because the minimum position size you can take in crude oil is usually much larger than in a Forex currency pair too.

For example, let’s compare the positively correlated USD/CAD Forex currency pair (more on that later) with crude oil. Most Forex brokers will allow you to buy or sell only $1,000 worth of Canadian dollars, but the minimum transaction size for crude oil is often about five times higher, at the current market price (100 barrels of oil at roughly $50 per barrel). True enough, there are an increasing number of brokers allowing a minimum size of only 10 barrels of oil per trade, and if you are lucky enough to find one, this problem almost goes away. Trading Crude Oil

The next issue is the high volatility of crude oil. Over an average week between 2001 and 2014, the price ranged by 7.28%. Compared to the same value exhibited by the USD/CAD Forex currency pair, which was 1.92%, the volatility was almost 3.8 times as great. Just to show that these values were not overly distorted by outliers, the respective median values were 6.38% and 1.69%. So, you can see why, when trading crude oil, you are going to need much wider stop losses than you will with Forex, and so the volatility-adjusted minimum effective position size in crude oil becomes greater than the corresponding Forex value.

Finally, in long-term trades, crude oil often carries higher overnight financing charges than the Canadian dollar.

Substituting Crude oil for the Canadian Dollar

I mentioned earlier that there is a correlation between the prices of the Canadian dollar and crude oil. Using the same weekly historical data discussed previously, there is a correlation coefficient between the two of 0.34. This is a reasonably high level of correlation considering the high time frame used in the calculation (weekly) and the 13-year back test period. That means that the prices tend to move the same way, which is not surprising, as Canada is a major oil producer (ranked 5th in the world) and exporter (ranked 4th in the world). There are only two countries with larger known oil reserves than Canada. These facts make the “Loonie” (as the Canadian dollar is widely known) a major “petro-currency” whose relatively value is highly dependent upon the price of oil.

This means that if you are reluctant or unable to trade crude oil directly, for whatever reason, you could consider using the Canadian dollar as a substitute, with the USD/CAD pair being the obvious choice as the pairing is with the U.S. dollar, the same way crude oil is traded in U.S. dollars.

Correlation Trading

The relatively high correlation offers more opportunity than substitution: it can also be a basis for trading strategies. If we assume that the correlation is due to the price of crude oil acting as a kind of leading indicator of the future price of the Canadian dollar, then we could wait for oil to get significantly ahead or behind and be ready to trade the Canadian dollar in the same direction.

Another possible related opportunity lies in waiting for any significant divergence between the price movements of crude oil and the Canadian dollar, then taking equally weighted positions (by volatility measured by a long-term Average True Range value) in each instrument in the direction of their convergence. Divergence is usually most easily measured by using the same long-term moving average on charts of the same time frame for each pair.
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