The price of crude oil dropped below $45 a barrel on Wednesday for the first time since March. This follows a level of around $48.5 last Friday, a decline of more than 4%. The continuing decline of oil is due to mounting concerns surrounding oversupply and the lower demand from China due to the economic slowdown the country is experiencing.
A known and strongly negative correlation exists between the US dollar to the Canadian dollar (USD/CAD) currency pair and the price of oil; when oil weakens so does CAD, hence USD/CAD price rises. By comparing the two charts below this correlation is clear.
Crude oil is Canada’s largest component of exported goods hence CAD weakens as oil prices fall. In addition, the price of crude oil is denominated in USD therefore the USD/CAD correlation is intensified (i.e., when USD strengthens, oil price falls and USD/CAD rises).
Due to this strong correlation many investors find ways to trade oil through trading USD/CAD. Tomorrow the US Non-Farm Payroll (NFP) data and unemployment rate in the US and in Canada will be released at 12:30 GMT. These may strongly effect the USD/CAD currency pair and as a result, the price of oil.
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A strong correlation can be used in a trading strategy which involves hedging. For example, opposite positions for two strongly correlated assets can ‘cancel’ each other out providing you with protection. Based on this logic, if you believe that oil will rally more than USD/CAD will decline, you may purchase both assets. On the other-hand, if you believe USD/CAD will decline more than oil will rally, you may sell both assets. You can position yourself in the spot and futures market and also through buying options. Options are known for their limited risk when purchased.
Below is an example position using the ORE platform using Call options on USD/CAD and oil, with the expectation for one asset to rally more than the other declines, by August 13 (which includes the EIA oil data release, one day before). A Call option gives the right to buy an asset at a certain price over a certain period of time.
The first option is on WTI OIL, to buy 100 barrels $44.47 (an at-the-money strike price) to expire in 7-days. The cost to buy this option is 100.24 USD (or 91.85 EUR):
The second option is on USD/CAD to buy 10,000 USD at 1.3166 (at-the-money strike) to also expire in 7 days. The cost to buy this option is 81.15 CAD (or 56.48 EUR):
The total cost (and hence total risk) to enter this position is 148.33 EUR. If WTI OIL rallies more than USD/CAD falls, the WTI OIL option will gain in value with unlimited profit potential and the USD/CAD option will lose but with limited loss hence your overall position may profit (i.e. when the net position is worth more than the 148.33 EUR premium paid). Alternatively, if USD/CAD rallies more than WTI OIL falls, the USD/CAD option’s value is unlimited on the upside and the WTI OIL option’s loss is limited.