STRATEGY 13: COMMODITY CORRELATION (PART 2)

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1 STRATEGY 13: COMMODITY CORRELATION (PART 2) The correlation coefficient is a number that describes the extent to which two instruments are correlated to each other. The number oscillates between 1 and +1. Commonly mistaken as a momentum oscillator, the correlation coefficient is instead a number that moves from periods of positive correlation to periods of negative correlation. Located on one end of the spectrum, +1 is considered a state of perfect positive correlation between the two instruments. If the number is anywhere between 0 and +1, the two instruments move in the same direction but with varying degrees of positive correlation. On the other end of the spectrum, 1 is considered a state of perfect negative correlation between the two instruments. If the number is anywhere between 0 and 1, the two instruments move in the opposite direction but with varying degrees of negative correlation. For much of 2011 and 2012, the correlation coefficient for gold and the dollar index was between 0.6 and 0.8. This means that if the dollar index was up, there was a 60% to 80% probability that gold prices would come down. In contrast, if the dollar index was down, there was a 60% to 80% probability that gold prices would go up. Here we explore how to trade spot gold using the U.S. Dollar Index as a reference. The U.S. Dollar Index is an exchange-traded index that represents the value of the U.S. dollar in terms of a basket of six major foreign currencies. These are: Euro (57.6%) Japanese yen (13.6%) UK pound (11.9%) Canadian dollar (9.1%) Swedish krona (4.2%) Swiss franc (3.6%) The price action of the dollar index gives us an idea of how the U.S. economy is performing compared to other major world economies. On August 15, 1971, the United States unilaterally terminated the Bretton Woods system of having the U.S. dollar pegged to gold at USD35 an ounce. At the same time, the U.S. dollar became a reserve currency. The U.S. Dollar Index was started in March Its beginning value was Historically, from 1967 until 2012, the Dollar Index averaged 98.51, reaching a historical high of in February 1985 and a low of on March 16, 2008, during the global financial crisis.

2 Gold prices, however, have steadily been climbing. The end of 2011 marked the eleventh straight year of gold s spectacular bull run, hitting a record high of USD1920 an ounce on September 16, This strategy seeks to exploit the inverse relationship between the Dollar Index and the price of gold. According to the World Gold Council, While holding all else equal, gold tends to rise when the US dollar falls. In November 2010, Federal Reserve chairman Ben Bernanke announced a second round of quantitative easing (QE2) by injecting USD600 billion into the financial system. The added supply of US dollars in the system caused gold prices to hit record highs within a month. In September 2012, in a move widely touted as QE3, the Federal Reserve said it would expand its holdings of long-term securities with open-ended purchases of USD40 billion of mortgage debt a month. The announcement caused the price of gold to hit a 7-month high. With central banks worldwide taking unprecedented measures to ensure ample liquidity in the global financial system, the inverse relationship between the Dollar Index and gold prices looks set to continue. Let s see how this strategy works. Time Frame The commodity correlation strategy works with the daily candle (D1). This means that each candle on the chart represents 1 day of price movement. Indicators We use the ATR indicator. Currency Pairs Use spot gold or XAU/USD only, with the price action of the Dollar Index as a leading indicator.

3 Strategy Concept The price action of the Dollar Index is used as a reference to trigger a trade on the XAU/USD. Technical levels of support and resistance on the Dollar Index chart are used to spot long and short trades on XAU/USD. If a candle closes below support on the Dollar Index chart, a long trade is triggered on the XAU/USD the following day. Similarly, if a candle closes above resistance on the Dollar Index chart, a short trade is triggered on the XAU/USD the following day. The risk to reward ratio is set as 1:3. A bigger target is employed to allow the trade to run its course. Long Trade Setup Here are the steps to execute the commodity correlation strategy for long: 1. Identify the support of the Dollar Index chart on the daily time frame. 2. Identify a candle that closes below the support. (See Figure 9.17.) 3. Enter long on gold (XAU/USD) at the opening of the next day s candle. 4. Set the stop loss at twice the ATR as the previous candle, which is 2,664 pips (1,332 2). 5. Set the profit target at a risk to reward ratio of 1:3. In this example, the profit target is 7,992 pips (2664 3). (See Figure 9.18.) From the short example in Figure 9.19: Entry price = Stop loss = Profit target =

4 FIGURE 9.17 Identify a Candle that Closes Below Support FIGURE 9.18 Set Stop Loss and Profit Target The risk for this trade is 2,664 pips, and the reward is 7,992 pips if the profit target is hit. The risk to reward ratio is 1:3, which yields a tidy 9% return if we take a 3% risk.

5 FIGURE 9.19 Trade Hits Profit Target Short Trade Setup Here are the steps to execute the commodity correlation for short: 1. Identify the resistance of the Dollar Index chart on the daily time frame. 2. Identify a candle that closes above the resistance. (See Figure 9.20.) 3. Enter short on gold (XAU/USD) at the opening of the next day s candle. 4. Set the stop loss at twice the ATR as of the previous candle, which is 8,044 pips (4,022 2). 5. Set the profit target at a risk to reward ratio of 1:3. In this example, the profit target is 24,132 pips (8,044 3). (See Figure 9.21.) From the short example in Figure 9.22: Entry price = Stop loss = Profit target = The risk for this trade is 8,044 pips, and the reward is 24,132 pips if the profit target is hit. The risk to reward ratio is 1:3, which yields a tidy 9% return if we take a 3% risk.

6 FIGURE 9.20 Identify a Candle that Closes Above Resistance FIGURE 9.21 Set Stop Loss and Profit Target

7 Strategy Roundup Part of the commodity correlation strategy seeks to take advantage of the positive correlation between oil prices and the CAD/JPY currency pair. Using oil prices as a reference, trades are triggered on the CAD/JPY. This strategy is especially suited to traders who would like to trade oil but prefer not to experience the volatility associated with it. FIGURE 9.22 Trade Hits Profit Target Part 2 of the commodity correlation strategy seeks to take advantage of the negative correlation between the Dollar Index and gold prices. Using the Dollar Index as a reference, trades are triggered on XAU/USD, which is the price for spot gold on FXPRIMUS. With the Federal Reserve announcing its plans to keep interest rates low until the middle of 2015, the inverse relationship between the U.S. dollar and gold prices looks set to remain. This strategy is ideal for gold traders all around the world because it provides an objective way to take an entry for gold, using the Dollar Index as an important reference.