How to Trade Currency and Commodity Correlations

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How to Trade Currency and Commodity Correlations

Correlations exist between the world’s most traded commodities and currency pairings. The Canadian currency (CAD), for example, is tied to oil prices owing to exporting, but Japan is vulnerable to oil prices since it imports the majority of its oil. Similarly, Australia (AUD) and New Zealand (NZD) are closely tied to gold and oil prices.

While correlations (positive or negative) might be substantial, if forex traders wish to benefit from them, they must be appropriately timed. There can be occasions when a partnership fails, and these times may be quite expensive for a trader who is unaware of what is going on. Being aware of a connection, monitoring it, and timing it are all important components of effective trading based on inter-market insight given by evaluating currency and commodity linkages.

Key Takeaways

  • Currency traders may profit from the fact that some currencies are associated with commodities prices.
  • This is often the case when a country’s economy is heavily reliant on natural resources.
  • When commodity prices rise, the currencies of such countries tend to appreciate, and vice versa.

Deciding Which Currency and Commodity Relationships to Trade

Not all currency/commodity correlations are trading opportunities. Traders must consider commissions and spreads, as well as extra costs, liquidity, and information availability. Currencies and commodities that are extensively traded are simpler to locate information about, have lower spreads, and are more likely to have appropriate liquidity.

Canada is a big oil exporter, thus the price of oil and the quantity it can export effect its economy. Because Japan is a large importer of oil, the price of oil and the quantity it needs purchase have an impact on the Japanese economy. Because of the importance of oil in Canada and Japan, the CAD/JPY has a positive correlation with oil prices. This pair, as well as the USD/CAD, may be watched. The disadvantage is that the CAD/JPY has a wider spread and is less liquid than the USD/CAD. Because most oil is purchased in US dollars, the shifting currency has an influence on oil prices (and vice versa).Given that the two nations are significant oil importers and exporters, the USD/CAD is also worth monitoring.

Figure 1: CAD/JPY versus adjusted oil prices. Chart shows weekly data for 2007 through 2010. Image by Sabrina Jiang © Investopedia2020
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Figures 1 and 2 illustrate that the currency pair and oil have diverged at times. Through 2010, a high connection can be shown, demonstrating the need of real-time correlation monitoring using actual transaction data.

Figure 2: CAD/JPY versus unadjusted oil futures (percentage terms). YTD (2010), daily. Image by Sabrina Jiang © Investopedia2020

Australia is one of the world’s leading gold producers. As a consequence, the price of gold and the amount it can export have an influence on its economy. New Zealand is a large trade partner with Australia, making it particularly vulnerable to changes in the Australian economy. This implies that Australia’s gold relationship has a significant impact on New Zealand. Australia was the world’s fourth-largest gold production in 2008. The United States was the third-largest buyer of gold in 2009. As a result, the AUD/USD and NZD/USD are appropriate for trading in connection to gold prices.

Figure 3: AUD/USD versus adjusted gold futures (percentage). Chart shows weekly data for 2007 through 2010. Image by Sabrina Jiang © Investopedia2020

While Australia was one of the lesser volume oil exporters in 2009, the AUD/USD was likewise strongly connected to oil prices throughout 2010, until diverging in September.

Figure 4: AUD/USD versus unadjusted oil futures (percentage). YTD (2010), daily. Image by Sabrina Jiang © Investopedia2020

Currency commodity linkages are subject to alter throughout time. Other currency commodity linkages might be discovered by searching for significant exporters as well as major buyers of the same product. For a correlation with the commodity, look at the currency cross rate between the exporter and importer.

Deciding Which Instrument to Trade in

After determining which currencies and commodities have significant correlations, traders must determine which tradable currency pair to trade in, or whether to trade in the commodity and currency. This will be determined by a variety of circumstances, including costs and the trader’s ability to access a certain market. According to the charts, the commodity is often the most volatile of the instruments.

Due to the extensive usage of commodity contracts for difference, a trader may be able to trade the commodity and currency pair from a single account if they are available (CFDs).

Monitoring the Correlation for “Cracks”

It is also important to note that just because a link occurs “on average” across time does not imply that it exists at all times. While some currency pairings are worth keeping an eye on because of their high correlation inclinations towards a commodity, there will be occasions when the strong correlation does not exist and may even reverse for a period of time.

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A commodity and currency combination that is strongly connected one year may diverge and become negatively correlated the next year. Connection traders should be aware of when the correlation is strong and when it is fluctuating.

Correlations may be readily monitored using current trading systems. A correlation indicator displays the real-time correlation between a commodity and a currency pair over a specific time period. A trader may want to take advantage of minor divergences while the two instruments remain strongly connected overall. When divergence persists and the correlation weakens, a trader must take a step back and recognize that the correlation may be in a period of deterioration; it is necessary to step back or adopt a new trading strategy to match the changing market.

Figure 5: CAD/JPY versus oil futures and correlation indicator. Chart shows weekly data for 2008 through 2010. Image by Sabrina Jiang © Investopedia2020

Figure 5 shows the weekly CAD/JPY rate as well as the 15-period correlation indicator when compared to oil futures. The indicator has a good connection in the 0.80 range most of the time, although there are periods when the correlation drops. When the indicator falls below a specific level (say, 0.50), the correlation is weak, and the trader may wait for the currency and commodity to re-establish a strong connection. Divergences may be utilized as trade signals, but keep in mind that they might linger for a long time.

The correlation indicator may be customized for the time period on which a trader is trading. A longer calculating time smoothes out the findings, which is preferable for long-term traders. Shortening the computation period causes the indicator to be more choppy, but it may also produce short-term indications and enable for correlation trading on smaller time frames.

Timing the Currency/Commodity Trade

Based on the previous charts, it is clear that a timing strategy is required to navigate the shifting connections between currencies and commodities. While the trader’s specific entry and exit points will be decided by whether they are trading the commodity, currency, or both, a trader should be conscious of many aspects while entering and leaving correlation trades.

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  • Are currency and commodity prices now linked? What about in the long run?
  • Does one asset seem to be more important than the other?
  • Is there a pricing divergence? Is one asset class, for example, hitting greater highs while the other asset class fails to achieve higher highs? Wait for the two to start moving together again if this is the case.

Make use of a trend confirmation tool. If divergences develop, watch for a trend (or reversal) in which the currency and commodity move in their respective associated fashions.

Image by Sabrina Jiang © Investopedia2020

Several trades in the USD/CAD and oil markets may have been validated by monitoring correlations throughout the time range shown in Figure 6. While the pairs may be traded at correlated periods, there were significant divergences over this time range. Large patterns emerged when the currency and commodities markets realigned. Several big trends may have been recorded by looking for breaches in trend lines in both commodities and currencies, or by waiting for one asset class to join the correlation trend of the other asset class. This is analogous to looking for divergences in the correlation indicator and then entering a trade in the trending direction when the commodity and currency realign. It is possible to trade commodities, currencies, or both.

The Bottom Line

Currency and commodity correlations are not a precise science. Correlations often break down and may even reverse over lengthy periods of time. Traders must be watchful in looking for chances in correlations. This work may be completed using correlation indicators or monitoring charts. Waiting for the commodity and currency to align in their respective trends after divergences may be a significant signal – but traders must recognize that divergences might persist a long time. Relationships may vary over time when nations modify their exports or imports, affecting correlations. Traders must also decide how they will make deals, whether in the currency, the commodity, or both.

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