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Dealing in the Spot Market

Dealing in the Spot Market

An effective forex trading strategy does not have to be limited to only forward contracts. At times, Trading foreign currency directly in the spot market, at the current spot rate, is the most effective strategy for a business to minimize its costs or maximize its profits. Sometimes, it can be more profitable to execute a currency exchange at the current spot rate to take advantage of favorable pricing for a product, or to receive payment immediately from a client, regardless of what the current spot rate is.

But even when transacting in the spot market, there are various tools a firm can use to maximize its profit (or minimize its loss) on the currency exchange. There are various types of trade orders a firm can utilize in a foreign currency strategy, which give flexibility in limiting the price at which it can buy or sell a currency in the spot market, to prevent surprises should prices rise or drop while the currency exchange is being executed. Some of these trading tools are briefly outlined here:

Limit Order

Limit orders are used to buy or sell a specific amount of a foreign currency at a specified exchange rate (or better). A buy limit order will only be triggered at the specified FX rate (or lower); whereas a sell limit order will only be triggered at the specified FX rate (or higher). For example, a business places a buy limit order to exchange $10,000 U.S. Dollars for Euro, but only if the Euro spot rate reached $1.10 or lower.

Stop Loss

A stop loss order protects the value of a business’s currency holding by establishing a “floor” on an acceptable exchange rate. This floor represents the maximum the business is prepared to lose on the currency trade: if the value of its currency holding declines below the floor, the holding is liquidated (sold) to ensure that the business doesn’t lose value (or if the floor is set below an exchange rate in which there is already a loss of value, it can serve to limit further losses).

One Cancels Other (OCO) Order

By combining a limit order with a stop loss order, and adding the condition that if one of these orders is triggered then the other is canceled, a one cancels other (OCO) order is created. For example, an OCO order can be used to set an upper limit order and a lower stop loss order at which a currency holding is to be sold. If one is triggered, the other is cancelled, thus the currency holding is free to trade within this pre-set range.

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What is Contango

Contango: Understanding Advanced Commodities Trading

Futures trading is all about analysing the future prices of commodities. To trade futures effectively, it is important to understand some technical terms that relate futures prices to current spot prices. One such term is contango.

Contango refers to a situation where the futures price of an underlying commodity is higher than its current spot price.

Contango is considered a bullish sign because the market expects that the price of the underlying commodity will rise in the future and as such, participants are willing to pay a premium for it now. For instance, if the spot price of gold is currently $1860, and the futures price is $1950, then the commodity is said to be in contango. 

Q&A: Is gold usually in contango? The answer is a definitive yes! In fact, most commodities are usually in contango. The premium paid above the current spot price is usually associated with carrying costs.

These are costs, such as storage or warehousing, insurance and forgone interest on money tied down to the commodity. This is a reason why commodities, such as gold, are perpetually offered at a premium in the futures market.

As the maturation date draws near, it is always observed that the forward price of gold in contango converges downwards towards the commodity’s future spot price.

The opposite is observed in backwardation, where at maturity, the forward price of gold will converge upwards towards the expected future spot price of gold.     

Contango has manifested numerous times in the markets throughout history. As a case, consider the oil price shocks in the 1970s through to the 1980s.

In mid-1980, oil was priced above $100 per barrel, but by early 1986, the price had plunged to lows of circa $25 per barrel.

In late 1998, the commodity was priced at around $14 per barrel, but it rallied all the way to circa $140 per barrel by mid-2008.

There have been more swings since then and as of December 2020, the commodity trades in the $45 – $55 range per barrel.

The above price fluctuations explain why market participants are more than willing to engage in contango in the market. It provides a unique opportunity to protect themselves from the unpredictable commodity price swings in the market that can severely puncture their bottom line.

For instance, it is common (almost standard) for airline companies to routinely purchase oil futures to bring stability in both their business model as well as their returns.

It would simply be disastrous if these companies would be buying oil at their market prices when required. These companies would likely collapse at some point. The purchase of futures contracts helps the companies to plan for stable prices for a guaranteed period.

Over the long run, the actions of market participants rebalancing their portfolios can impact asset prices. When futures contracts are bought, the increase in demand causes an increase in short term prices. But now, with the market flooded with future supply, prices consequently come down, effectively removing contango from the market.

This can naturally lead to backwardation, a situation that many financial analysts and experts believe to be the norm in commodities trading.

Backwardation is when futures prices are lower than current spot prices. This is a common scenario for perishable goods, and it leads to more demand in the future, less supply, and consequently higher prices.

But for non-perishable goods, with high carrying costs, the consensus is that they offer a great opportunity for buying call options in the futures market. This makes contango more commonplace.

Understanding Contango In Action

As mentioned, in contango, forward prices are higher than spot prices.

The opposite phenomenon is backwardation, where forward prices are lower than the spot price.

In contango, forward prices trade at a premium to spot prices mostly due to high carrying costs.

These are costs, such as storage fees, cost of financing or insurance charges. Because the opinions and perceptions of market participants (investors, traders and speculators) change continuously, forward price curves in the market can easily toggle between contango and backwardation.

A backwardation forward curve will show lower future prices and higher spot prices. This is because of the convenience yield.

The convenience yield is the benefit or implied return on holding commodities physically rather than future contracts. It is the premium derived on carrying costs.

Convenience yield exists when carry costs are low and it is beneficial for participants to hold large inventories for the long run.

The convenience yield will be low when warehouse stock levels are high and it will be high when warehouse stock levels are low.   

Backwardation can also occur when producers want to cushion themselves from the price uncertainties in the financial markets.

This is the scenario that famed economist Keynes described in his normal backwardation theory.

The theory states that sellers would be willing to sell an asset (commodities, like gold or oil) at a discount to the expected price to offset the impact of volatility in the financial markets.

For instance, a major oil-producing country may be willing to lock in futures prices that are lower than the expected prices to provide economic stability to its populace.

This begs the question: is contango really bullish or bearish? In contango, the futures prices of a commodity are expected to be higher than the current spot prices.

Still, the forward price curve will converge downwards to meet the expected spot price at maturity.

Despite this, it does not matter since contango is a bullish situation simply because the expectation of market participants is higher market prices in the future. Investors are optimistic that the prices of the underlying commodity will appreciate in the future.  

The Convergence of Futures Prices and Expected Spot Prices

The reason why traders or investors watch contango and backwardation is because of the relationship it details between futures prices and spot prices. This is important information for speculators because it will determine whether they go long or short at any given time, based on where they expect future prices to go.

The definition of contango is a situation where market participants are willing to pay a premium for the future prices of a commodity.

There are many reasons for this. They may not desire to pay insurance for the entire period, storage fees, or risk damage, theft or any other unexpected price fluctuations in the market.

But even so, at maturity, the forward price curve always converges downwards to match the prevailing spot price. If this does not happen, an arbitrage opportunity will occur in the underlying market that will basically offer “FREE MONEY” to traders.

Whether the situation in a market is contango or backwardation, the fact that at maturity, the forward prices curve converges to meet the spot price offers immense trading opportunities for speculators.

During contango, the idea will be to go long on futures contracts as the expectation is that prices will continue drifting higher. But as maturity nears, the idea will be to go short on futures contracts as forward prices converge downwards to meet the spot prices.

This will be true in the case of a backwardation situation. When maturity is still far away, speculators can go short as future prices are expected to edge lower. But as maturity nears, the idea will be to go long as forward prices converge upwards to meet the spot prices.

The conclusion is that both contango and backwardation simply reflect the opposite sides of the same coin. They also both offer exciting opportunities for both short term and medium-term speculation.

Contango FAQs

  • Is contango a bullish or bearish market indication? Contango is an indicator of bullish sentiment in the market. This is because the price of the underlying asset is expected to drift higher well into the future. Market participants are willing to pay more for the commodity in question as time goes by. A bullish market is one in which prices make higher highs and higher lows, and this is what a contango situation in the market implies for futures prices. On the other hand, backwardation is a bearish indicator because market participants believe prices will edge lower as time goes on.
  • When is contango bad? It is important to note that futures contracts have a delivery date – they cannot be held indefinitely. Consumers that want to be delivered the commodities will have no problem when the delivery date is due, but there is a concern for investors that only speculate on the underlying commodity with no intention of actually owning it. To go around this, issuers of the commodity ETF use what is known as ‘rolling’. This involves selling near dated futures and buying further dated futures of the same commodity. This allows investors to maintain exposure to a particular commodity. It is important to note though that rolling also comes with additional trading costs, both in the value of the futures contract and rolling charges. 
  • When is contango good? Contango also has its advantages. Some arbitrage opportunities may occur and this will allow traders to buy assets at spot prices and sell at future prices, pocketing the difference. In cases where inflation is rising, there is the opportunity to buy futures contracts with the expectation that prices will continue edging higher and higher as time goes by. This is an inherently risky strategy though, because it only works when prices continue to rise.
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Correlation Trading

In the world of financial trading, asset correlation establishes how and when the prices of different financial instruments move in relation to each other. With regards to currencies and forex trading, correlation is the behavior that certain currency pairs exhibit where they either move in one direction or in different directions, simultaneously:

A currency pair is considered to be positively correlated with another if their values move in the same direction at the same time. A good example of positively correlated currency pairs is the GBPUSD and the EURUSD. When the GBPUSD trades up, so does the EURUSD.

A negative correlation between currencies occurs when there are two or more currency pairs that trade in opposing directions simultaneously. A good example of this phenomenon is the USDCHF and EURUSD. When the USDCHF falls, the EURUSD often trades up, and vice versa.

Types of Correlation

There are three recognizable forms of asset correlation: positive, negative and no correlation. If two assets’ prices move up or down in the same direction simultaneously, they show a positive correlation, which could be either strong or weak.

However, if an asset tends to move down when another rises, then the correlation is negative. The level of correlation is measured as a percentage figure, from -100% to 100%, also known as a correlation coefficient and it is established by analyzing the historical performance of the assets.

For instance, if two assets have a correlation of 50%, it means that, historically, when one of the assets’ value was rising or falling, there was a corresponding rise or fall in the same direction in the value of the correlated asset, about 50% of the time.

Conversely, a -70% correlation means that analysis of historical market data shows the assets moving in opposite directions at least 70% of the time. A zero correlation means that the asset prices are completely uncorrelated. This means that the movement of the price of one asset has no noticeable effect on the price action of the other asset.

It is also essential to understand that the fact that correlations exist on average over a period of time, does not necessarily mean they exist all the time. Currency pairs or assets that may be highly correlated one year, could diverge and show a negative correlation the following year.

If you decide to try out a correlation trading strategy, you need to be aware of times when the correlation between assets is strong or weak, and when the relationship is shifting.

Correlated Assets and Asset Classes

It is common to find correlations between the most heavily traded currency pairs and commodities in the world.

For instance, the Canadian dollar (CAD) is correlated to the price of oil since Canada is a major oil exporter, while the Japanese yen (JPY) is negatively correlated to the price of oil as it imports all of its oil. In the same way, the Australian dollar (AUD) and the New Zealand (NZD) have a high correlation to the prices of gold and oil.

Airline stocks and oil prices.

Stock Markets and gold offen, but not always.

Large-cap mutual funds generally have a high positive correlation to the Standard & Poor’s (S&P) 500 Index.

Correlation-Based Trading Strategy

While positive and negative asset correlations have a significant effect on the market, it is vital for traders to time correlation-based trades properly. This is because there are times when the relationship breaks down – such times could be very costly if a trader fails to quickly understand what is going on.

The concept of correlation is a vital part of technical analysis for investors who are looking to diversify their portfolios. During periods of high market uncertainty, a common strategy is to re-balance a portfolio by replacing a few assets that have a positive correlation with some other assets with a negative correlation to each other.

In this case, the asset price movements cancel each other out, reducing the traders risk, but also lowering their returns. Once the market becomes more stable, the trader can start to close their offset positions.

An example of negatively correlated assets that are used in this type of trading strategy is a stock and a Put Option on the same stock, which would gain in value as the price of the security drops.

Why Is Asset Correlation Important to Investors?

In the world of investment and finance, asset correlation is studied closely since asset allocation is aimed at combining assets that have a low or negative correlation in order to lessen portfolio volatility. Having a combination of assets with a low correlation reduces the portfolio’s volatility. This gives a trader or portfolio manager room to invest aggressively.

What it means is if a trader is ready to accept a certain amount of volatility, then they can put their money into high return/risk investments. This combination of low/negatively correlated assets in order to lower volatility to acceptable levels is known as portfolio optimisation.

Risk Management Tips for Correlation-Based Strategies

Sound risk management is essential when making investment decisions in order to lower the adverse effects if you suffer a loss. By using the modern portfolio theory, it is possible for you to reduce your overall risk within your portfolio of assets, and possibly even boost your returns overall, by investing in positively correlated assets.

This strategy will allow you to capture and mitigate for small divergences as the asset pair stays highly correlated overall. As the divergence of the asset prices continues and the correlation begins to weaken, you need to carefully examine the relationship to find out if the correlation is deteriorating. If so, you should exit the trade or take on a different trading approach in reaction to the change in the market.