Categories
Forex Assets

Little Known Facts About the Connection Between Crude Oil and Forex

Just as it is possible to use the movements of the Crude Oil market to identify trends by fundamental analysis or macroeconomics, this information can be very useful in the trading of foreign exchange and other types of Petroleum-related financial assets. In this article, we explain how the interpretation of oil price movements can be useful for a Forex trader when examining the relationship between Crude Oil and Forex markets. 

We will also explain why it would be useful to pay attention to Crude Oil prices in order to formulate a successful foreign exchange trading strategy. For those who want to trade with Crude Oil itself, this asset is offered to operate by many online Forex/CFD brokers.

Oil Price Movement and Forex Trading

Many countries in the world, such as Mexico and Saudi Arabia, depend heavily on their oil exports, especially in terms of budget and overall economic performance of their country. Crude oil is an essential commodity for the functioning of the modern world, so an increase in the price of oil is often related to inflation, economic growth, and the price of other goods, especially prices, Consequently the demand for products made of Petroleum.

The movements of the Crude Oil market are of great importance for the Petroleum producing economies and their derivatives, not only in terms of the formulation of policies but also the forecasting of local economic results. This is also true for the rest of the world, as it is impossible to imagine our current economic system without black gold, so that information can be useful in shaping our expectations with regard to inflation and other macroeconomic factors.

Oil Price Movements and Exchange Rates

We have already mentioned that there are countries that depend heavily on their oil exports. This is important not only because a bad year in the oil markets could affect the economic performance of these countries, but also because oil prices and quantity variations often affect the exchange rate of these countries.

Take Canada as an example. Like many other countries, Canada is highly dependent on its exports to the rest of the world, but as one of the world’s leading oil producers, You should not be surprised that Crude Oil is the main source of Canada’s total foreign exchange earnings, especially because Crude Oil is traded in US Dollars.

Movements in the price of crude oil and exchange rates. In other words, an increase in the price of crude oil (assuming constant demand) often means an increase in the supply of US Dollars in the Canadian economy. This tends to drive the exchange rate down, as Canadian dollars would now be relatively scarcer compared to the number of green dollars currently circulating in the economy. The opposite, of course, is also true: the fall in oil prices means that Canada will receive fewer dollars per barrel, which implies a lower offer of US Dollars in the economy and an increase in the exchange rate, given the relative shortage of US dollars.

As a merchant, there are ways to take advantage of Oil’s price movements by trading Crude Oil currency pairs, especially if you are reluctant or unable to trade directly with Crude Oil.

An “Oil Pair” in Forex is USD/CAD since the Canadian Dollar is the largest substitute for Oil in the global Forex market. This pair tends to increase in value when the Oil market is in decline and decreases in value when the market skyrockets, meaning that it may be possible to formulate a strategy to operate this pair based on the movements of the Oil market price.

Other currencies benefit from a positive correlation with Crude Oil, such as the Norwegian Crown and the Russian Rouble; however, these tend to have low liquidity, which means that it may be more difficult to take advantage of the relationship between these currencies and Crude Oil, at least compared to other Forex correlations. This means that trading with oil currency pairs like USD/NOK or USD/RUB can be more difficult, at least compared to other Forex “oil pairs” that tend to be more liquid, such as USD/MXN or USD/CAD.

As for the prices of crude oil and the value of the American Dollar relative to other currencies, there used to be an inverse relationship between them, but that has changed over time. The inverse relationship was especially true when the United States was considered as a net importer of petroleum, but the situation has changed significantly in the last decade since the United States became a major supplier of oil and a major influence on world crude oil prices. Now the correlation tends to be positive, although it should be noted that this has been anything but constant over time.

Oil Price Movements and Fundamental Analysis

Just as crude oil prices can influence foreign exchange rates, they can also affect the fundamentals that play a role in the valuation of some currencies. As we said, there are countries that depend heavily on their oil exports, for example, Mexico, Norway, and Venezuela. Because of this, unfavourable oil price movements affect the perceptions of traders and investors about the intrinsic value of their currencies. For this reason, it should not be a surprise to see traders fleeing from currencies like the Mexican peso into “safer assets” when oil prices collapse.

The opposite is also true. Rising oil prices could favor certain currencies. For example, because of Mexico’s vast oil reserves, positive movements in the price of crude oil tend to favour the performance of the Mexican Peso. Oil and Analysis Fundamentally, this correlation is not perfect, especially because there are other factors that could affect the fundamental evaluation of any currency, regardless of the country’s dependence on oil markets.

An example of this, at least in the long term, is the performance of the Norwegian Crown. As we know, Norway is a major energy producer, since oil accounts for about 62% of its exports. However, the correlation of this currency with the price of crude oil is very volatile and tends to be lower when oil markets recover. This has led some analysts to believe that, although positive price movements favour the Norwegian economy, the relationship between the performance of the Norwegian Krone and the price of Brent crude oil in the neighbouring North Sea is not very clear.

In any case, there seems to be a stronger correlation when the price of crude oil is falling, so it may be possible to benefit from this positive Forex correlation when the oil market collapses.

Crude Oil and Other Assets

As it is possible to trade Forex currency pairs based on Crude Oil price movements, traders can also take advantage of the relationship between the movements of the Oil market and other assets, particularly other commodities. There is, for example, a well-known (though not statistically constant) correlation between the price of crude oil and the price of gold. As an essential commodity, the increase in crude oil prices tends to increase inflationary pressures worldwide, so when oil prices skyrocket, this tends to increase inflation in the long run.

Gold is a well-known “safe haven value” against inflation and times of crisis, so should come as no surprise to see traders rushing toward this precious metal when they fear the continued depreciation of the world’s major currencies. Silver and other precious metals tend to have a very positive correlation with gold, so there may be an opportunity to take advantage of other Forex correlations.

On the other hand, falling oil prices tend to exert downward pressure on inflationary trends, which tends to hinder optimism about United States treasury yields. Oil prices also greatly influence global economic performance, so when crude oil prices rise too high, this tends to hamper economic growth, causing traders to rush to alternative assets such as gold. The gold supply chains themselves are also strongly influenced by what happens in the oil markets. Oil is widely used in gold mining, so rising oil prices tend to affect the margins of gold mines, affecting the supply of metal.

Another asset that has a well-known, albeit difficult, relationship with Crude Oil is natural gas. Historically, both commodities have moved together, as they were often positively correlated, but this relationship has changed significantly over the past decade.

Crude Oil Prices and the Foreign Exchange Market: Trading Opportunities

Abrupt market movements can be an opportunity to trade in currencies and other financial assets that have a positive (or even negative) correlation with Crude Oil. This means that a stock market crash may present an opportunity to sell energy shares, or to be long in the popular Crude Oil currency pairs like USD/CAD and safe-haven assets like gold.

On the contrary, a positive outlook for the stock market may be an opportunity to short the currency pairs of Crude Oil, or to be long in commodities that tend to have a positive correlation with the price of Crude Oil.

Categories
Forex Assets

What’s Really Happening With Oil?

Oil price action in the past 5 years has been a headline, especially once the pandemic hit the world. The global activity shrank causing oil futures to plummet to zero. A rare occurrence like this is a fortune for some and misery to others. The steep decline attracted a lot of reversal traders picking the dips, unfortunately for them, the price kept going down to some would say impossible levels. Trend-following strategies enjoyed this plummet. A few years before, the price reached very high levels, you could see a lot of complainers about the price of gas and other derivatives, something they do not have control over. In every situation, there is someone who is not happy, however, you can be the one who just reaps the rewards when the oil goes up and down. There is a choice to be the one who is taking the hit or be the one who is hitting. 

Trading oil will likely take a lot of trial and error when making a transition from forex trading. Oil, like precious metals, is a commodity, it is physical with real supply and demand. Whatsmore, oil can be a political tool, and it is also connected to world economic activity. It has been and still is one of the global primary energy sources. Consequently, your trading system will need adjustments before you get it right. If you are following our previous articles about the algorithm and the way we adjust it for precious metals trading after forex, you will quickly adapt it to oil. 

Oil trading is done with the CFD contracts, meaning traders can go long and short like in forex and have leverage, although not as high as with forex. CFDs can have any asset underneath and leverage gives traders additional buying power if needed, however it is a double-edged sword for beginner traders without good risk management if any. CFDs on oil are not available in the US since the Dodd-Frank Act after the 2008 financial crisis. There are other ways to trade oil this way for US citizens, though.

Brent and West Texas Oil are the two oil types traded, both are popular yet certain prop traders think WTI oil is a better choice since the price action is smoother. Both charts are extremely similar so traders can pick one. Oil is expressed in the USD, at least that is the standard offer you will see on the broker list. Other currencies are redundant since oil does not really care how the dollar is doing, the effects of the dollar movements on the oil are not significant. According to certain prop traders, it’s probably the most detached asset from the USD after palladium. Since oil is traded in USD globally, some countries do not like this fact and are trying to introduce closed markets where the USD is not used, most of these countries are big oil exporters. 

Natural Gas is also offered with better product range brokers, although natural gas price action is not very friendly, similarly when we compare gold and copper. Oil is far more traded asset so there is no need to take risks with other more exotic assets unless you have exhausted all other major markets. News about the USD is also one of the uncontrollable risks we do not have to account for since oil is very strict about its value, even when the USD is strong the oil price is steady. On the other hand, oil is very sensitive to global political events, such as war tensions, recent pandemic situations, and OPEC deals. So when we do fundamental analysis, we need to pay attention to a completely different set of news and events. These events are for most of the time unexpected and unscheduled, an uncontrollable risk we have to accept if we trade oil. There is nothing we can do, these events just pop up but we can still be positive in the long run regardless. The price after such events may spike but understand these are not common events and the spikes are not always going to adversely affect your trade. After all, you may be ending by having profit spikes since the events can cause the price action in the direction of an already established trend, further pushing it. We will address one point where oil price reaction could have ruined your trade later.

Correlation with oil is one of the most popular technical analysis we see, yet be warned correlations come and go and cannot be applied effectively in trading according to prop traders. Correlations are commonly explained by many educational websites and books but in practice, they are not consistent enough for traders to rely on. You can test this claim in a demo account if you can make a trading plan that identifies conditions for a trade entry, following the correlation between assets. The Canadian dollar is commonly explained as the currency to go if you want to use price action information for trading oil. CAD is considered positively correlated to oil, still, you can see if this is true and how consistent it is. Now, when the oil price action is mostly flat since the COVID-19 pandemic extreme bearish move, we cannot see a steady correlation to CAD at all. In the picture below we have marked sections where there is a positive correlation between CAD (orange line) and WTI (black line) into no correlation and even into a negative correlation period, all separated by green vertical lines.

If somehow you have a plan for how to use this correlation period, you would likely have more losses than winners in the future giving how inconsistent it is. 

Brokers will have different product symbols in the platform list for oil CFDs, for example, “WTI”, “US Oil”, “USOUSD” or “WTIO” for WTI oil, and “UK Oil”, “UKOUSD” and so on for Brent. Brent oil is like silver is to gold when we talk about price action and volatility. It has more choppy periods, sudden moves and generally is less smooth than WTI. Since we are trading just one of them, you can pick WTI. The charts between the two oil types almost look the same, just Brent is a bit more amplified. 

If you are using the ATR indicator to measure the volatility of oil assets, you will notice it is the same as with the JPY currency pairs. Volatility is an important part of the algorithm we have talked about in previous articles and oil does not have anything different here. Trends need volume or volatility to keep the trend going, otherwise, we end up trading false breakouts. Trading precious metals required some changes from forex but trading oil retains the relation of volume to trends. 

Not that ATR value can be different on the same oil asset but with different brokers. Sometimes this difference is dramatic; it can affect your position sizing (for the ones using our system). The reason for this might be because some brokers record Sunday flat candles (periods). When these count into the ATR they drastically lower its value. If you think this changes something you are wrong. Your position size might be a bit larger for the lower ATR but the end pip performance is the same. After all, just pick the broker you like regardless of this chart behavior. 

The algorithm structure is the same except we do not include the baseline. The baseline element does not have a good effect on trading since we have supply and demand, and this also opens room for reversal trades. The algorithm structure also contains two confirmation indicators and one trade exit dedicated indicator. These indicators need to be switched for some that perform better on oil. Of course, in some cases your forex or precious metals indicators may work as well but know if the system is not giving consistent results, switch these first. Note both precious metals and oil are commodities, so start with the algorithm made for metals and then make adjustments if needed. You will probably find indicators that work better on oil and even small odds in your favor per trade create drastic performance differences at the end of the year. 

Now about the events you cannot control regarding the oil, if you follow political events, after 13th September 2019 an Iranian oil tanker got shot and caused the incident in the oil market. The price went up but your pending orders, more importantly, Stop Loss orders would get passed. The gap when the price opened was extreme to the point it resembles a flash crash in forex. According to the price action, you could be in a long position as we see higher lows and highs before the spike, or you could have avoided all of this if your volume/volatility indicator filtered the signal. However, even if you were in a short position, do not let this loss deter you. It is the long game you are aiming at, just move on as nothing happened. These events are very rare, nothing similar can happen in the next decade, anomalies are part of the trading. Some traders could leave these positions open after the spike in hope of a reversal since the jump was extreme, but traders that follow a system accept the loss. The worst-case scenario for those that left the position open is now a possibility, the price could have continued up and cut a large part of their account or completely erase it depending on how long they wait for a reversal. This damage can only be repaired with year-long profitable trading. Those who cut the position immediately, they are still profitable at the end because it is the long game that matters. They will embrace this loss every time. 

In conclusion, add oil into your trading arsenal if you are already successful with forex and precious metals. The algorithm that works with metals is going to work with the oil too, and with adjustments, you will have another profit maker asset. Unpredictable events with oil are part of the trading risk you will need to take, but this will not make a dent in your overall, year after year performance. Don’t worry about the USD strength, trade it even before the USD important event. The knowledge you have with trading and the algorithm you have created is universal, and by knowledge we also mean the skill set and the mindset. The testing phase for every system is a must, do not expect great results just because one system is good with forex currency pairs. Oil is something completely different fundamentally and technically.