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by Brynne Kelly

July 24, 2017

What Does An ‘OIL GLUT’ really mean?

The terms “glut” and “oil” have become almost inseparable the past 18 months.  Fueled by an obsessive focus on inventory and production levels, it has become an easy narrative.

The Cambridge English Dictionary defines a ‘glut’ as:

A supply of something that is much greater than can be sold or is needed or wanted.

A glut is often associated with low prices, or an expectation of low prices.  An extreme example of a supply ‘glut’ can be seen in the electricity markets through real-time electricity prices.  Whereas most commodity markets exist with a storage system under-pinning them,  this is not the case for electricity markets (but for limited battery and hydro storage).  As a result, when power has been generated in excess of demand, market prices have to move low enough to clear this excess supply.  As a matter of fact, this market clearing price can even be less than zero (negative), meaning the producer has to PAY the consumer to take the product off their hands.  The negative price reflects the ‘cost’ the consumer incurred to accommodate that supply into their system.  Without a storage system in place, market regulations require utilities to hold enough generating capacity to cover the highest projected demand for the year plus a reserve margin.

A robust storage system helps to smooth day-to-day and seasonal differences in supply and demand and reduces traditional production capacity requirements.  In this way, storage acts as an alternative form of supply and demand by allowing product injections during times of over-production for use in times of under-production.  The natural gas market in the US is a good example of this.  Total natural gas production capacity exceeds total demand in the summer, but isn’t enough to meet total demand in the winter.  Using storage however, production can continue at a relatively stable level throughout the year, with excess being injected into storage in the summer for use in the winter.

Storage levels then become the ‘glut’ indicator, unlike the electricity market which doesn’t have a buffer between differences in supply and demand.  At the extremes, conventional storage systems either become too full to accommodate additional supply, or too low to accommodate projected future seasonal demand.  In either case, price signals emerge in an attempt to rectify the situation.

Perceived versus Real “Glut”

An inventory shortage or excess can be either perceived or real.  Real inventory issues show up in the spot market.  Perceived inventory issues are based on assumptions.  These assumptions are anticipated as threats to the spot market at some point in the future and are expressed via the futures market.  If these assumptions don’t manifest into the spot market over time, assumptions regarding the ‘future’ will ultimately be revised.  Think of flowers delivered on Valentine’s Day.  A month in advance, the market establishes a clearing price for flowers delivered exactly on February 14th.  There are even discounts offered for flowers delivered the day before or the day after February 14.  These are based on perceived value.  Come Valentine’s day, those who forgot to place their order and need flowers are now forced into the ‘spot’ market and may be willing to pay multiples of the original price for delivered flowers, or they may luck out and find an overzealous store stuck with too much delivery capacity.

With that in mind, let’s circle back to the aforementioned ‘glut’ in the oil markets.  The prevailing narrative is that there is too much supply for the current level of demand.  The evidence being used to support this narrative is inventory levels.  High inventory levels are perceived as a threat to the spot market.  As long as there is still room to fill conventional storage, producers have the option of storing their barrels or selling them.  In this way, spot prices are linked to futures prices.  In a perfect world, the difference (spread) between the spot price and the next futures price should reflect the cost of storage capacity.  Of course, the cheapest storage options will be used first.  As these fill up, spreads may widen to value the next most economic form of storage and so on.  This is why it has been traditionally assumed that a widening spread, or contango, may be signaling a market oversupply.  On the other hand, if spot prices are higher than futures prices, those with barrels in storage will withdraw stored barrels to capture a higher spot price and eliminate storage costs.

Take a look at the 1-month price spreads in WTI futures since the beginning of 2017:

At the beginning of the year, the front of the futures market was trading at a slight contango from one month to the next (the black line above).  However, starting with the Dec-17 contract, the market had moved into ‘backwardation’.  This market structure makes the decision to store barrels uneconomic and should have induced producers to sell their barrels into the spot market.  You can see that by June, the backwardation in the futures curve had been pushed back 3 months (the grey line) and by last week that backwardation was gone.

The effect of the shape of the term structure seems to have had the desired effect on inventories, as storage has been drawn down significantly since April:

Total Petroleum inventories have been reduced by over 50 million barrels since the beginning of April, 2017.  This is significantly higher than inventory withdrawals in the prior 3 years.  As a result, total inventory levels are now slightly below where they were at this time last year but still above levels of the prior 3 years:

Once the incentive to store barrels was reduced, they were instead pulled out of storage and moved to market.  Pulling over 50+ million barrels out and selling them into the market put pressure on the front of the futures curve relative to the back (seen in the chart below):

As a result, the December 2018 contract is now close to $2.00 over the December 2017 contract.  While that may sound like a lot, it’s just a little over $0.15 a month compensation to defer payment on your production.  Since the seller of oil doesn’t receive payment until after the oil is delivered, holding it in inventory doesn’t generate cash.  As a matter of fact, holding oil in inventory costs money (via the tank storage cost).  With all the news coverage this past year regarding the need for cash, it’s no surprise producers would rather sell now versus hold inventory.

Days of Supply

Oil inventories are often expressed as “Days of Supply”.  This is essentially total inventories divided by daily demand.  Over the past 10 years, we have gone from just under 25 days of supply to a little over 30 days as production has increased and demand has flattened (as seen below).

This assumes oil inventories can transported to refineries to be processed as they are withdrawn.  I use ‘days of supply’ to put the phrase ‘inventory glut’ into perspective.  Is just over a month’s worth of crude oil held in inventory to meet our current demand needs something you would consider excessive?  Since we still rely on imports for over half of our crude oil needs in the US, this doesn’t scream ‘excess’ to me.  But, as in any business, holding inventory is expensive and it’s a delicate balance to determine the optimal balance between margin and cost.  Assuming there are decent margins to be made, it would be logical to assume more inventory would be held at low prices versus high prices.

What is The Signal?

As Nate Silver discussed in his book “The Signal and the Noise” (2012), we seek to extract signals and eliminate noise when building models with historical data to
predict the future.  However,  while the final outcome of an event is subject to influences that will repeat themselves in a foreseeable way in the future, it is also subject to a great deal of noise that will not repeat itself in the future in a predictable manner.

I believe the ‘signals’ we have been receiving from the oil market have moved from ‘price’ signals to ‘volatility’ signals.

Increased production and storage capacity in the US have reset oil prices from $90 to $45 in the past 2 years. As a result, production costs have been targeted and optimized.  What remains is a larger, more efficient system with a lower convenience yield that may be less prone to significant price moves in either direction.

However, low volatility also makes it more difficult to justify new assets as it reduces projected returns (all other things being equal).  With long lead-times to build new assets like pipelines and export infrastructure, a sustained period of low volatility will have impacts not realized for many years in the future.

 

 

 

 

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July 5, 2017

Understanding The “Mexico Deal”

 

So, you’ve heard about this large oil transaction that has the potential to move markets and wanted to know more?  In the article below, I use this transaction as a means to delve in to the structure of the type of trading group that might participate in this deal. From there, I then take a deeper look at the transaction itself and the complex hedging decisions those that participate might face.  With this information, you will learn where to look for any related trading opportunities.

We know that several years ago the Mexican government implemented an annual crude oil hedging program as part of their budget process.  Their intent is to protect the oil revenue defined in their yearly budget through the purchase of put options.

Recently, knowledge of this deal has received more press and it is now widely anticipated as a transaction large enough to move markets.  To understand the process that occurs from deal negotiation through deal closing, let’s first take a look at the structure of the trading desk.

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Trading desk structure

To understand how large deals like this unfold, it’s helpful to understand the different roles on a large integrated trading desk, specifically the trader and the marketer roles.

You may have noticed that many of the large banks and integrated energy companies out there have what they call their “Trading and Marketing” group.  That’s because they are actually two distinct functions that depend on each other to make money.

Trading and Marketing roles defined

The trading desk manages a portfolio of risk exposure, executing strategies to capture anticipated market moves.  They are usually governed by Value at Risk (VAR), Volume, and Credit limits.  VAR is a common measure of how much a portfolio might lose (gain) given normal market conditions for a given confidence interval (probability) and liquidation period.  It is a measure of market risk.

When working inside a large institution where capital constraints like margin are monitored at the corporate level, it’s more relevant to assign VAR limits at the individual trader or desk-level rather than assign margin limits.

In addition to VAR limits, traders or trading groups are often assigned volume limits.  These volume limits are often assigned the total portfolio level, the individual market level, or both.  The rationale for volume limits is to prevent position size from impacting the liquidity-portion of the VAR calculation, among other things.  It’s not an exact science, and in my career I have certainly run up against assigned volume limits before my VAR limits.

The introduction of central clearing has simplified portfolio credit risk in listed products, however, it is still an issue for non-listed products.  There is still a vast world of over-the-counter (OTC) transactions with non-standard terms, non-standard durations, non-standard grades and variable volume requirements.  These transactions are enabled by direct credit agreements negotiated between counter-parties in the deal.  As a result, corporate or portfolio-level credit exposure limits by counterparty are established to ensure exposure to a particular counterparty doesn’t exceed collateral agreements.

The marketing desk in a trading business usually focuses on originating non-standard transactions directly with another counterparty.  Typically a marketer within an energy trading group might be assigned a region of the US and work to build relationships with both producers and consumers within that region.  For example, they may have an industrial client that is looking to buy 800 Mmbtu’s of natural gas delivered to their plant location via pipeline in southern Alabama.  This is not the standard 10,000 Mmbtu exchange-traded natural gas future.  Since the marketing role is to originate business directly with customers, versus take risk, the marketer will bring the terms of the deal to their internal trading group for them to quote a price.

There can be a lot of discourse between the trading and marketing groups regarding deal valuation.  Marketers generally don’t manage market risk, they manage relationships. They are primarily measured on the amount and quality of the deals they close.  Conversely, a trader is measured on the returns they generate from the portfolio they manage.  Once a deal is closed, it is transferred to the trading desk to manage.  Some groups establish a ‘transfer price’ at which the deal is moved into the trading ‘book’ from the marketing ‘book’ in an attempt to capture any value (a marketer’s negotiation skills) added to the sales/purchase price over and above the trader’s quoted price. Ultimately, the more deals the group as a whole gets a look at the more they are aware of what is going on in the market, which is valuable information.

It would be reasonable to assume that the opportunity to participate in the Mexican hedge deal originated through the marketing group and the relationships they have created over the years.  It’s also reasonable to assume that these marketers work closely with their internal trading desks regarding the terms of the deal so that their traders can establish a market price at which they are willing to transact.

Why do I assume this?  Deals like the Mexican oil hedge require a lot of contracts with specific negotiated terms (credit, margin, legal, etc).  This requires a lot of time, which is something that traders on a desk don’t usually have.  This is clearly a deal done directly between two counter-parties, contains non-standard terms (if it was a simple put option on WTI futures, it could be executed via the exchange) and its contract language would have to be carefully monitored and updated each year.

The benefit of being a Market-Maker

Market-making on a trading and marketing desk, as described above, refers to the internal process of the traders providing market prices to the group’s marketers on deal opportunities they originate from their customers.  Once the marketer has obtained a price from their trading desk and established how long that price is good for (1 hour, 1 day, etc.) they submit them to the customer.  Often times it is unknown how many other companies the customer is soliciting markets from.  Because markets are submitted directly to the customer, they are not public which makes for a distorted feedback loop.  You generally have no idea what prices your competition gave to the customer, but can only assume that if you didn’t win the deal, you did not provide the best price.

Over the years, I have worked with marketers and participated in pricing long-term, non-standard deals.  In most cases the counterparty needs either variable volumes, obscure delivery points or an illiquid grade of product.  The counterparty has often reached out to several companies to ensure they are getting competitive prices.  This is why an active trading desk is needed as part of an overall group.  Being active in the physical and financial markets every day gives traders the knowledge needed to understand market dynamics and the performance risk they are being asked to ‘price’.

One thing is for sure:  the fewer market-makers and the less liquid the product being priced, the more opportunity there is for adding larger premiums to your markets.

It’s fairly common for markets to have large annual or seasonal transactions that occur due to regulatory requirements, hedging or procurement. Some of these transactions are governed by regulatory rules regarding the type of counterparty that can participate.  These rules are typically related to the size and credit-worthiness of the participants.  Limitations on the number of participants limits the amount of competition and increases price mark-ups (mark-downs).

Which brings me back to the annual hedge by the Mexican government, as the above speaks to the rumored ‘large fees’ made by those that qualify to make markets for this deal.  I believe “large fees” relates to how wide one can make their market.

Due to the size of this deal, and the potential pay-outs, Mexico is interested in dealing with counter-parties that are well collateralized with the ability to pay out large sums in the future should their option go ‘in-the-money’. There is nothing worse than having a winning trade on your books only to have your counterparty go bankrupt or become unable to pay (as happened to many when Enron filed for bankruptcy).

Electricity Market Example

To illustrate that deals like this occur across all industries, let’s take an example from the electricity market that I am familiar with.  The electricity market is regional with listed futures contracts for major pricing hubs within each region.

There are two main listed futures for each pricing hub:  On-peak and Off-peak think high-sulfur and low-sulfur crude oil grades).  In the eastern time-zone, On-peak contracts cover the 16 hours (7 AM-10 PM) on each week-day of the month. The Off-peak contract covers the 8 hours (10 PM-7 AM) on each week-day of the month and also the entire 24 hours for each weekend and holiday in a month.  The volume for each of these contracts is, for the most part, 50 MW/hr multiplied by the number of On or Off-peak hours in each month.

An electricity marketer communicates with many different types of customers to originate a deal (large industrial users, builders of new generation, etc.) When a customer is looking to transact, they provide the terms of what they are looking for and the deadline for prices to be submitted.  In this example, let’s say that the customer is a large industrial company that is growing and needs to purchase additional electricity to cover that growth.  Their plant is located in Pennsylvania and they provide the following estimated usage curve indicating how much they are looking to buy each hour:

The customer has requested a fixed price quote (given this usage curve) for a 5 year term.  The volume of the futures contracts traded in the market are for 50 MW/hr blocks, while the volume the customer needs per hour varies throughout the day. Hedging this deal using futures contracts will leave the trader with excess during some hours and shortages in others.

Just as demand varies by hour, so do prices (as illustrated in the graph below).

You can see that using the standardized futures contract as a hedge would leave the trading book with excess length during the hours of the day that prices tend to be the lowest, and with shortages with during the hours of the day that prices tend to be the highest.

The trader will factor this into their model when crafting their offer price.

Here are a few basic hedging scenarios that might take place if they win the deal and it ends up in the trading book (as a sale to the industrial customer):

  • Buy a 50 MW block of on-peak futures (7 AM-10 PM, Mon-Fri) and stay short the off-peak hours (nights and weekends),
  • Buy a 50 MW block of both On and Off-peak futures which makes the net position fairly flat during on-peak hours, but net long during off-peak hours,
  • Do nothing – it’s a nice compliment to the trader’s overall bearish positioning and view that futures prices are headed lower

Of course, there are other options besides using futures contracts.  This deal may be somewhat offsetting to an existing position already in the trading book (in which case the trader might have an incentive to offer a better price to the customer because it relieves some headaches and locks in some profit).  The trader could also utilize a combination of options, however, options on electricity futures that settle against the hourly price averages are fairly expensive due to the higher volatility of hourly prices versus daily.

Other factors that affect hedge activity relate to corporate-imposed risk limits (volume and VAR limits).  Some deals are large enough that they would cause the trading portfolio to exceed their risk limits, if not hedged immediately.  Of course, you can see from the example deal above that it’s not always possible to hedge ALL of the risks immediately in some deals (like the variable hourly volumes and prices).  However, if the size of the new deal is enough to put the portfolio over volume or VAR limits,action must be taken immediately using liquid futures.  Post-mortem analysis will determine what net risk is left in the portfolio to manage (i.e. basis, location, quality, volume, etc.).

This is when a trader assesses their ‘net risk’.  Ending up long basis (spread) as a result of hedging is still a trade.  Would you buy that basis (go long) regardless?  If not, sell basis.

Deconstructing the Mexican deal:

Using the knowledge of the overall dynamics reviewed above, let’s look at how that might apply to the Mexican deal.

We know that roughly 95% of the crude oil that Mexico sells to the US is Maya heavy crude for use by Gulf Coast refiners.  Pemex (Mexico’s state-owned petroleum company) calculates their sales as a derivative of other market prices.   Their current formulas are:

Since over 95% of Mexico’s crude oil sales to the US are of Maya crude, that’s the formula we will look at for this analysis.  Maya’s value in the Gulf Coast is  indexed to a basket of 3 crude oil grades and 1 fuel oil grade, plus a constant (K) commonly called the K-factor.  This constant is updated monthly and posted on their website (found here) as seen below:

There are a lot of moving parts, each having different sets of price influences and drivers.  Also interesting to note,  WTI is not used directly in any of these formulas.  This is what Pemex states on their website regarding their pricing formulas:

First, let’s use what we have learned so far to evaluate the deal that was done for 2017 (the deal runs annually from Dec 1 – Nov 30).

Deal Assumptions: 

(see August 29, 2016 WSJ article)

 

 

 

The term of the deal has historically been 12 months running from December to the following November.  Using all of this information, it’s fairly straight-forward to pull together a back of the envelope analysis of the 2017 performance of $38.00 options against the market:

I pulled monthly posted prices (for US delivered Maya crude) from the EIA website for the beginning of 2017 and used the Pemex formula for the balance of the year.  It doesn’t appear that any of these puts would be in the money.  Given that market prices are only modestly above the strike, this is not great news for Mexico since they are net long oil. The premium they paid would be much easier to stomach if oil prices had moved much higher.  Cashing in on their puts is not actually the goal here since this is basically catastrophe insurance.  Any ‘gain’ derived from this insurance really just represents an overall loss of revenue on their total oil production.

With that in mind, take a look at Maya oil prices in the chart below:

With the Pemex formula and the futures curves for each of the 4 benchmarks, you can get a feel for 2018 Maya ‘futures’.  What strike level, if any, will they consider for next year?

For reference, futures curves can be seen in the table below:

For those who are more ‘visual’, here are the futures curves as of July 5, 2017:

The unknown in the calculations above for future terms (besides movements in outright price) is the Pemex published “K-factor”.  I used the posted K-factor for June 2017 (shown earlier) as a constant for the balance of the year and 2018.  While Pemex is responsible for setting the K-factor, it seems to be loosely correlated to the LLS/Brent spread.

Analyzing the Risks to the Market Participants in the Annual Mexican Hedge Deal

A recent Bloomberg article shed a lot of light onto this transaction.  One thing the Bloomberg author noted was that changes in bank regulations may be impacting post-deal activities:

Putting aside that a bank may have multiple trading groups and portfolios that ‘take the other side’ of any hedges they transact, I will focus on the market risk that a single portfolio involved in this deal might face rather than the corporate-level net portfolio.

We know that in the past the options purchased by the Mexican Government are primarily based on the underlying price of Maya, and to a lesser-extent, Brent.  I will assume that would again be the case for 2018.

As already mentioned, we know that Maya’s price is derived as a percentage of WTS, High sulfur fuel oil (HSFO), LLS and Dated Brent prices plus the variable constant set by Pemex.  This gives us the ability to understand the risks the seller of these options will need to lay-off once the deal is done.

Primary price exposure:

  • WTS
  • USGC HSFO
  • LLS
  • Dated Brent

Secondary price exposure created as a result of hedging (since it’s highly unlikely the seller can equally offset their exposure using Maya futures):

  • WTI/Brent Spread
  • LLS/Brent Spread
  • Brent/Oman Spread
  • USGC LSFO
  • Dated Brent/Brent Futures
  • Light/Heavy Crude Oil Spread
  • WTS/Canadian Heavy Spread
  • Etc.

For example, if risk were entirely laid-off using WTI futures the book is now exposed to any significant change in WTI’s relationship to Brent.  Another risk the seller of the options might incur relates to the expiration differences between monthly and average price options (it’s been noted that the deal is comprised of a basket of Asian, or average-price options).  To the extent that European or American options are purchased as a hedge, the option seller will still have to manage the difference between hedges using monthly strikes and the average of daily Index postings that are used to settle Asian options.

Looking at the market risks identified above, you get a sense of how complicated a hedge strategy could become.  Any unexpected shift-change in the relationship of the hedge contract to the underlying products used to price Maya (i.e. WTI suddenly trading at a premium to Brent) could seriously impact the hedge effectiveness.

It’s unlikely that there is a deep, liquid market for over-the-counter Asian options on Mayan Crude.  Therefore, hedging this deal will require the use of a mix of more liquid futures and options markets.  Determining the optimal mix of products to use is an art and a science.  The ‘art’ being any market bias regarding price direction and spreads.  The ‘science’ being the use of statistical tools and models.

How would you decide to hedge this trade?  Two statistical tools that are often used when evaluating effective hedge markets are ‘correlation’ and ‘r-square’.  Correlation measures the strength and the direction of a linear relationship between variables.  R-square measures the proportion of the fluctuation of one variable that is predicted from another variable(s).

Shown below are two simple correlation tables for the markets used in the Maya pricing formula (based on 2 different sets of historical price data):

 

In both time series, one thing that stands out is the high correlation between Maya and LLS oil price moves.

Since WTI and Brent are the two most liquid futures contracts, I went on to include historical WTI prices in the mix (even though WTI isn’t specifically included in the Maya price formula) and ran correlations again, using the same two historical time periods:

With the addition of WTI, we reveal a high correlation between WTI and WTS (which is a main component in the Maya price formula).

 

 

 

Price correlations provide useful insight.  To get more specific however, the R-square coefficient is used to define the usefulness of those correlations.  R-square is a measure of how much the variance of ‘y’, or in our case “Maya”, is explained by the model of continuous predictors “x” (in our case WTI, Brent, LLS, WTS, HSFO)

R-square outputs (using the same historical time series as presented in the correlation matrix) are shown below:

Each bar represents the historical price series used as well as which “index” variable is being compared to Maya.  For example, the first blue bar on the far left is the R-square of Maya and LLS prices using historical prices from 2015 through 2017.

Notice the difference in the results of the two historical time series used.  Specifically, the decline in the r-square of Maya vs HSFO (labeled R^2 HSFO above) in recent years.

This is obviously one of the problems with using historical time series data.  The changing nature of spread relationships can be significant and render older data useless.  Two years ago, heavy crude oil was pricing significantly below lighter grades, however, those relationships have changed with the OPEC cuts that started last year (which took the production of heavier grades off the market raising their price relative to lighter grades).

We could go on and on using various statistical models, but you get the idea.  The point is to get a sense of how those involved in the deal may look to hedge.  With both LLS and Brent showing the highest correlation and therefore, r-square values with respect to Maya, WTI may not be the hedge of choice.  With WTI as one of the more depressed light grades in the market lately, using it as a hedge leaves the portfolio essentially “long” Brent and LLS (the result of selling puts on Maya crude) and short WTI.

Said another way, the trader who has hedged with WTI has now made a market call on the Brent/WTI spread.  Selling put options (i.e. to the Mexican government) creates ‘length’ in a portfolio.  Think of this length as being related to Brent and LLS (and also WTS and HSFO).  Selling WTI futures to reduce

this length leaves the portfolio with a spread, namely long the Brent/WTI spread or long the LLS/WTI spread.

The knowledge of how such a large deal may be hedged can lead to trading opportunities.  For example, if I believed the initial hedges might be placed in the most liquid markets such as WTI, I might expect the Brent/WTI spread to widen in response to heavier-than-normal WTI futures selling.  Therefore, it might pay to go long that spread before hedging begins. The trader responsible for hedging this deal might also do the same hoping to pull some more profit out of the market from trading positions.  You can extrapolate this concept to High vs Low sulfur fuel oil, Gulf coast vs New York harbor spreads, etc.  My point is that outright price movement isn’t the only outcome here, and you might be well-served to look at how the various spread relationships are behaving.

Since the initial move in spreads after the OPEC cuts last year, the entire oil complex has remained closely linked.  A break-out move in any of these spread relationships might be a signal that significant hedging volume has entered the market.  Pay close attention.  Anyone who has significant volume to sell in the market might hit those that are less liquid first to ensure they can get some sales off before the market senses what’s coming.  Since selling pressure in WTI and Brent can pull the entire complex down with it, one trick traders use is to sell or go short some off the less obvious markets (WTS, HSFO, etc.) beforehand in hopes of capturing additional profit created by said hedge activity.

Just as spreads may widen, or prices may go lower when large selling pressure comes in to the market, remember that the counterparties that were directly involved in the deal may be left with significant spread risk in their book that will need to be managed.  Unexpected changes in price relationships can be exacerbated in the market as a result.

Bottom-line, there is more to this deal than meets the eye.  A simple expectation of lower prices due to hedging activity may not be the only market opportunity!

 

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Read More Brynne Kelly Research

Global Oil Spreads Are the Key to Balancing US Oil Inventories

Is a Rotation Out of Oil Into Equities Underway?

Putting Gasoline Inventory Build Into Perspective

 

 

 

 

 

 

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By Jason Pearce

The Two-Edged Sword

Archimedes made a great statement about the power of leverage when he said, “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”  That’s a great quote…until it gets misapplied to the arena of speculation.  Context is everything.

If you’re gonna talk about the advantage of using leverage in the financial markets, you would be irresponsible if you didn’t address a subject that’s intrinsically linked to it: risk.  If you want to learn the correct way to use leverage, you need to consider more than just the potential gains that leverage can bring.  You have to consider the potential losses.

The pros know that the winners take care of themselves.  It’s the losers that have to be managed.  The problem is, too much leverage can make the losing trades unmanageable even if you’re actively protecting yourself with stop orders.  Leverage is the how the markets provide a trader with more than enough rope to hang himself.

Leverage Levels

Currently, a stock brokerage firm will allow customers to trade with leverage of 2-to-1.  This is done by providing a margin loan to the trader.  If a trader has $100,000 on deposit, the brokerage firm will loan him up to $100,000 and allow him to buy $200,000 worth of equities.

So a stock trader with margin could double his money on a stock that increases in value by 50%…and just as easily wipe out his stake if the price of the stock was cut in half.

Many people believe that trading commodities is far riskier than trading stocks.  What?!  Trading corn is riskier than trading Tesla?!  This notion was likely brought about by the fact the available leverage for commodity trading is significantly higher than the leverage for stocks. So the belief is half right; commodity trading can be risker, but that’s because of the leverage available, not the instrument being traded.

That margin requirement to trade a futures contract is often around 5% of the value of the underlying contract.  For instance, the E-mini S&P 500 is currently worth around $120,000.  The initial margin requirement is $5,500, which is just 4.5% of the contract’s value.  This would allow a futures trader to potentially leverage his account at a level of 20-to-1 where $100,000 on deposit can control as much as $2 million worth of futures contracts.

At a level of 20-to-1, a fully margined commodity account would make a fortune on a modest price increase.  The other side of that coin is that the trader could also be completely wiped out on a 5% adverse move in price.

Forex trading reaches a whole different level of leverage…and insanity.  Those sleazy online “bucket shops” that are always trying to sucker the public into currency trading offer traders leverage of 50-to-1…and 100-to-1…and sometimes even 200-to-1.

Just think about that in dollar terms.  A $100,000 deposit in a forex account could control $5 million, $10 million, or even $20 million worth of currency.

At 100-to-1 leverage, it only takes a 1% change in price to double you money or lose it all.  What could possibly go wrong?

Too Much of a Good Thing

Just as leverage can amplify investment gains, it also amplifies invest losses.  This is why you never see professional traders and money managers taking full advantage of the leverage being offered.

It’s also why you’ve never heard of a professional trader racking up a month or even a year with a +1,000% return.  To knock it out of the park like that, you’d have to take way too much risk.

As a matter of fact, one professional trader I know gets very concerned if he makes too much money over a certain period of time!  His thinking is that he must be taking on too much risk or using too much leverage if the gains are accruing that quickly.

Professional traders make their trades based on probabilities.  But they manage risk based on possibilities.  If it’s possible for profits to snowball quickly, then it’s possible for losses to snowball quickly as well.  To keep a losing streak from turning into an avalanche you’ve got to put limits on the amount of leverage used.

Bond Bubble Blowup

C.S. Lewis wrote, “Experience: that most brutal of teachers. But you learn, my God do you learn.”  I’ve had the pleasure of having Professor Experience personally tutor me when I attended the University of Hard Knocks.  My major was in What Not to Do When Trading.

Let me first say that mean reversion works…eventually.  But if you’re going to make a bet on it and hold on, the trick is to make sure your position is small enough to survive the waiting period.  The more leverage involved, the less staying power you have.

When I was a wise old trader in my twenties, I picked a fight with the bond market.  Confidence and hubris was running high because I’d just come off of a couple of successful trade campaigns in the grain market and the Japanese yen.  And now that the Treasury market was running away to record highs, I put them in the crosshairs and went short.

T-bonds were around 124-00 at the time, which is a value of $124,000 per contract.  So initially, I went short one contract for every $20k in account equity and figured I could safely hold a contract with a $20k cushion and ride out the storm without needing a protective stop.  Based on the contract value, I was leveraged at 6-to-1.

T-bonds just kept ripping higher and posted a record string of daily gains.  Three weeks after I went short, I experienced an intraday drawdown of a little over $5,500 per contract.  Perversely, my losses were ratcheting higher by the day while the probabilities of a reversal also increased.

But don’t confuse probable with possible.

The six-figure open loss caused me emotional turmoil.  My $20k cushion shrank to $14,500 per contract.  I was down, but not out.  But I now had a bond contract value of $129,500 with a cushion of $14,500, raising the leverage to nearly 9-to-1.

Out of the Frying Pan

I called up another “professional” trader I knew in order to get his take on things.  He asked me about my conviction on the trade.  I told him I was still bearish and bonds just had to crash after a run-up like this!  Somehow, an old floor trader saying popped up: “When in trouble, double”.

So I did.  Seriously, I was already bleeding with a six-figure loss and then I proceeded to double my exposure by selling more contracts short at 128-24 ($128,750 value).  By doing so, my equity cushion was suddenly $15,250 for every two contracts.  Two contracts at that price are worth $257,500.  That spiked the leverage on the position to nearly 17-to-1.

As you would expect, Treasuries only accelerated from there.  The market posted daily gains and even some new all-time highs for several consecutive trading days.

When my trading accounts were just a stone’s throw away from a margin call, I finally tapped out.  I lost about $9k for each initial short contract and another $4,250 for each ‘add-on’ short contract.  My attempt at The Big Short wiped out two-thirds of my equity ($13,250 for every $20k), meaning a total loss of several hundred thousand dollars on the books.

Oh, and it gets even better…

As fate would have it, I covered all of those short positions just one day before the final record high was set!  Bonds tanked the very next day and started the multi-month decline I was anticipating…but without me in it.

There are a lot of lessons to learn from this story: Don’t bet the farm on one big trade, don’t fight the trend, don’t trade without protective stops (or at least options to hedge), don’t depend on the opinions of others, etc.

But one lesson I want to bring highlight right now is that of using too much leverage.

Had I stuck with the original (flawed) plan, which was a fully leveraged position of 6-to-1, I would have still had to endure a wicked drawdown.  But I would have never been forced to choose between liquidating or meeting a margin call.

By adding to a losing position and tripling my leverage to nearly 17-to-1, my protective buffer of equity was removed.  I had no more wiggle room when the trade went further against me and I had to get out.

Bottom line: the amount of leveraged used was the only difference between being able to weather a major drawdown until I could eventually get out with a profit or being forced out early with major losses.

Miscalculating Risk

I stated earlier that too much leverage can make the losing trades unmanageable.  A lot of times, this is due to the false sense of security that protective stops can bring.  You may think you know what your risk on a trade is, but sometimes you can be wrong.  Very wrong.

Suppose Sensible Sam is watching the soybean market and he thinks it’s about to take off.  He has $100,000 in his account and wants to risk three percent of his equity on a soybean trade.  That means he’ll have to put a protective stop order in the market to knock him out if the market moves against him by $3,000.

So Sensible Sam goes long three 5,000 bushel soybean futures contracts at $9.98 and places a protective sell stop at $9.78, which is twenty cents ($1,000 per contract) below his entry price.  Although he’s risking just three percent of his equity, Sensible Sam is moderately leveraged at about 1.5-to-1 because he has actually purchased $149,700 worth of soybeans ($9.98-per-bushel x 15,000 bushels = $149,700) with his $100k account.

Along comes Gunslinger Gary.  He’s also looking at the same soybean market and wants to get in on the action.  He’s been burned before by risking way too much of his equity, but he still wants to capitalize on the expected move in beans.

Gunslinger Gary has a brilliant idea: buy a ton of contracts and set a really tight protective stop.  Perhaps he is even going to follow Sensible Sam’s lead and risk just three percent of his $100,000 account…but that’s where the similarities stop.

Gunslinger Gary buys twenty 5,000 bushel soybean futures contracts at $9.98 and places a really tight protective sell stop at $9.95, which is just three cents ($150 per contract) below his entry price.  Theoretically, he’s only risking three percent of his equity.  However, trouble is brewing because Gunslinger Gary is leveraged at 10-to-1.  He has actually purchased $998,000 worth of soybeans ($9.98-per-bushel x 100,000 bushels = $998,000) with his $100k account.

Maybe Gunslinger Gary’s protective stop placement actually makes sense because he’s using intra-day charts to time a quick exit.  That’s not what I’m concerned about.  But we can’t escape the fact that he’s substantially more leverage than Sensible Sam.

Let’s forget about the best-case scenario where beans go ripping higher right after these guys get in.  Consider what happens if the market drops instead.

What if Gunslinger Gary’s protective stop is elected and he gets three-cent slippage on the fill?  He’ll lose $6k instead of $3k.  That’s double what he thought the risk was.

Or what if he manages to stay in the trade but an adverse crop report hammers the beans down 20 cents in the afterhours market where slippage is even greater or beans gap down in the morning (if he’s using pit-session stops only)?

In this scenario, Sam would also get knocked out of his three soybean contracts and suffer the $3k loss.  But good ol’ Gunslinger Gary would get murdered.  The 20-cent loss on his twenty soybean contracts would cost him a whopping $20,000.  That one trade would wipe out one-fifth of his account.

Although I used a hypothetical scenario to show the damage that leverage can inflict on a losing trade, don’t think for one moment that it’s not a plausible scenario.

Ask anyone who’s ever traded grains in the summer or had a position on when a crop report came out and you’ll hear tales about the market instantly moving limit.  Sometimes, the market will even move lock limit.  If you’re on the wrong side of that move, it means you can’t even get out at the market price!

Currently, the CME set the limit for soybeans at 70 cents ($3,500 per contract).  That limit amount can get raised by 50% in a heartbeat.

The takeaway here is that leverage is just as important –maybe even more so- than protective stop placements when calculating your true market risk.  Yes, you should have protective stops.  But you should also have leverage limits.  Leverage is like medicine: a little bit can help you…but too much will kill you!

Highly-Leveraged Is Relative

Most traders have heard the famous story about how George Soros “broke the Bank of England” by betting against the British pound back in 1992.

Soros’ right-hand man, Stanley Druckenmiller, was the one that pitched Soros the idea of shorting Sterling.  Druckenmiller said that Soros taught him to “go for the jugular” when you have a very strong conviction on a trade and to ride a profit with huge leverage.

Obviously, the plan worked.  They made over $1.5 billion on that trade.

Now, what many people don’t know is the size of that leverage on the trade.  Druckenmiller suggested to Soros that that they put 100% of the fund in the trade.  Soros disagreed.  He said they should have 200% in the trade.

Having 200% means leverage of 2-to-1.  That’s not 10-to-1 or 20-to-1 like a lot of novice commodity traders use and it’s certainly not 50-to-1 or 100-to-1 like the snake oil FX brokers tell the public they can use, either.

Druckenmiller said in one interview that the leverage at Quantum (Soros’s hedge fund) rarely exceeds 3-to-1 or 4-to-1.  So if one of the best traders in history doesn’t go beyond 4-to-1 leverage, why the heck would a lesser trader think that going 10-to-1 or more is a good idea?

Do keep in mind that just because they leveraged 2-to-1 does not mean that they were risking the entire amount.  Soros is known for taking a quick loss without regret if the market proves him wrong.

Market Wizard Wisdom

Larry Hite is one of the Market Wizards interviewed Jack Schwager’s famous book.  On the subject of leverage, he said that, “…if you leverage more than 3-to-1 that you are a loser. Because we found that if you did 3 to 1 you would have, even with perfect knowledge, you could go down a third.”

So here we’ve got yet another successful trader with several decades of performance to back his reputation, and he’s telling traders that the maximum leverage that they should consider is 3-to-1.

There are only two reasons I can think of that a person would use higher leverage than what the pros use: ignorance or greed.  And once you are made aware of the risk of using high leverage, you can no longer claim ignorance for your excuse.

Protect Yourself

Brokerage firms want you to use the available leverage.  The more you trade, the more commissions they make.  Don’t think for a minute that they’re going to step in and tell you that you’re taking too much risk.

Sure, the brokerage firms will issue margin calls.  But that’s not about protecting you; it’s about protecting them.  Brokerage firms don’t mind if you are burning through your trading capital.  “Churn and burn, baby.”  It’s just when the flames get too close by putting them at risk of a potential deficit that they’ll step in and tell you to wire more money to your trading account or liquidate your positions.

Surely, the good ol’ US government is protecting you, right?  Well, consider this: The SEC just approved the launch of a 4x leverage ETF.

I wrote in a prior post about how leveraged ETFs are constructed as an easy way to the poorhouse.  You can be right on the underlying market and still lose money.  That’s the effect that double and especially triple leverage ETFs can have.

But now the government is going to allow us to trade in quadruple leverage ETFs?!  Maybe it would be more accurate to re-label these genius derivatives as WTFs

The point is that nobody is going to be as careful about protecting your capital as you are.  To be successful, a trader and investor must be proactive and accept personal responsibility.  Part of this includes understanding and setting limits on leverage.

It Can Get Worse

Do you have a trading system that you’ve back-tested over decades of data?  Have you tested it on out of sample data as well?  Have you run a Monte Carlo simulation on it, too?  That’s good.  You’ve done your homework.

I’m sure you also remembered to factor in commissions and slippage in order to get a better feel for real world trading.  You now know what sort of worst case drawdown would’ve occurred, which can help you determine your comfort level for the amount of leverage you’ll use to trade it.  Time to get trading.

Not so fast!

The well-respected trader Peter Brandt said, “A trader’s worst drawdown is the one yet occur.”

Consider that fact that the worst drawdown in your back-testing record or even your real-time track record got that title by being even worse than all the prior drawdowns that preceded it.  That means it’s possible that another drawdown can come along and steal that title at some point.

All records were made by breaking another record.   That can be both a good thing and a bad thing.  On the subject of drawdowns, it’s definitely a bad thing.

Storm Prep

One simple way that a trader can build a protective buffer is to prepare for a drawdown that’s double the size of the biggest one to date.  This means adjusting your risk-per-trade to a level that will allow you to endure such a losing streak.

Furthermore, you may want to calculate what your entire portfolio risk is.  This means looking at the effect of a worst-case-scenario where every position in every sector of your account gets stopped out with slippage.  This drawdown is your Portfolio Meltdown Level.  It rarely, if ever, will happen.  But you still need to be prepared for the possibility of it occurring.

Does that Portfolio Meltdown Level make you sick?  Well, it’s a good thing that you’re calculating it then!  You just discovered that you’ve been taking too much risk…and you’re lucky enough to have not found out from experience.  Dial the Portfolio Meltdown Level back down to your comfort level.  Figure out what you want to set for your maximum risk level for each trade, for each sector, and for your entire portfolio.

Preparing a worst-case scenario defense plan also means reigning in the amount of leverage used.  Just because you have protective stops in for your positions, doesn’t mean your maximum expected risk level is guaranteed.  If some of the rock stars of the trading world think the maximum leverage they should use is 3-to-1 or 4-to-1, then perhaps you should consider adopting these levels as your maximum leverage limits as well.

We don’t know when the storm will hit, but we do know that it’s inevitable that it will happen someday.  Your job as a trader is to make sure that you are taking the necessary precautions to survive it.  Remember that your probabilities of trading survival are inversely correlated to the levels of leverage that you use.


More Articles by Jason Pearce:

US Dollar: The New Bear Market?

Equities: US Against the World

Profiting From Failure: The Wash & Rinse Trade, Part II

Profiting From Failure: The Wash & Rinse Trade, Part I

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

 

Continue Reading...

By Jason Pearce

The Greenback In the Red

There is some compelling evidence that suggests that the multi-year bull market in the US dollar has come to an end.  Monetary policy, cyclical and seasonal patterns, and the technical outlook all make a good case of further weakness ahead.

If the US dollar does continue its descent, the first order of business for traders is pretty straightforward: you should be short the US dollar and long some of the other currencies.  That’s a “no-brainer” right there.

Now if you do not fancy yourself as a currency trader per se, don’t dismiss this conversation just yet.  You’re other investments may still be greatly affected by the trend in the US dollar.  Even if you’ve stuffed all of your cash under a mattress or converted everything to gold instead of holding one of those pesky fiat currencies, the trend in the value of that dollar still has an impact on your wealth.  It will determine whether you are gaining or losing purchasing power.  Being unaware of the trend in the greenback is irresponsible and staying unaware is downright foolish.

You should also pay particularly close attention to the trend in the greenback if you trade/invest in commodities and raw materials.  The effect of the US dollar’s trend is probably most noticeable here.  A rising US dollar means that US goods are more expensive to the rest of the world, so demand softens.  Price follows.  Conversely, a declining US dollar means that US goods are becoming cheaper to the rest of the world, so demand and price will rise.  This isn’t always the rule, but it stands true the majority of the time.

Interest Rate Effect

Interest rates are a major driving fundamental factor for currency trends.  In broad strokes, currencies trends are expected to move in tandem with interest rate trends.  If rates are rising, the currency should rise.  Conversely, if rates are declining, the currency should head lower.  This is Economics 101.

On the surface, the correlation between rates and currencies makes sense.  After all, investors are yield chasers.  They want to own the currencies with the highest yield in order to get the biggest bang for their buck…or Euro…or yen, etc.

In real life, however, it’s not always quite that simple.  Currencies often have a tendency to lead the target by factoring in the trend in monetary policy.  It’s a good example of that old Wall Street saying, “Buy the rumor, sell the fact.”  This does not happen every single time, but it does seem to happen quite often.  Often enough to wonder why you ever bothered to take Economics 101.

The current trend for US interest rates is higher.  On December 14th, the Fed raised rates for the first time in a year.  They hiked again in mid-March and are expected to do so yet again in June.  As a matter of fact, there are many economists and Fed members who see a couple more hikes before the year is out.

During this current trend in monetary tightening, it appears that the news of higher rates is discounted.  The US dollar index peaked on January 3rd a penny and a half higher than what the day’s high was when the Fed first hiked rates in mid-December.

When the Fed hiked again on March 15th, the greenback actually dropped about a penny and a half.  It has made a series of lower lows and lower highs since then.

If this current behavior pattern persists, the dollar could experience even more weakness at the mid-June FOMC meeting.  This would simply confirm that the tightening cycle has been completely priced in.

Presidential Cycle

The US Presidential cycle shows that the US dollar index often surges after the election, despite who wins.  This rally finally runs out of gas just before the middle of the year after the election.

This year, it appears that the expected peak in the greenback came early.  On January 3rd the dollar crested at a multi-year high and has been working its way lower ever since.

The second half of the post-election year starts in just a few weeks.  This is where currency traders should be paying close attention.

According to the US Presidential cycle, the second half of the post-election year is an ominous time for the dollar as the roadmap points lower for the next two years.  Bounces are expected along the way, but if this cycle holds sway, they won’t last long.  Rallies should be viewed as temporary events and short sale opportunities.

Seasonal Pattern

Based on the greenback’s seasonal pattern, we’re just a month out from where a major decline could commence.  This dovetails perfectly with the projection of the US Presidential cycle.  If so, the next few weeks could present an ideal timeframe to watch for a short sale opportunity.

Before we talk about this seasonal outlook, though, it is important to keep in mind that the seasonal patterns and cyclical patterns do not tell the US dollar what it has to do in the future.  These patterns are a statistical measurement that tells us what the market has done in the past and provides a projection of the most probable outcome moving forward.  Still, it creates a well-worn path that, if used properly, a trader can use to get an edge.

When I say used properly, I mean combining it with price action and giving the current price action priority over the seasonal and cyclical patterns.  If the buck follows the same path in 2017, trade accordingly.  But if the buck deviates from the path, do not try to force it into complying with your wishes.  The market will quickly show you who the real master is.

Now, onto the seasonal pattern…

The US dollar index has a seasonal tendency to peak in the first half of March and then decline until early May.  The buck stuck to the script for this part of the year as the March high was posted on March 2nd and the dollar headed lower for the next two months.

From early May though the start of July the greenback has a seasonal tendency to rally sharply.  So far, that has not been the case in 2017.  The buck has bucked the pattern as it moved lower throughout the month of May and recently touched the lowest price since the Presidential election took place.  This right here is a prime example of why traders need to obey price over seasonal patterns.

The first week of July is supposed to mark an important seasonal top that is followed by an overall decline until late October.  Around Independence Day, we should expect fireworks in both the literal and the figurative sense.  Currency traders should monitor the US dollar index closely once the second half of 2017 is underway.

A perfect setup from here would be for the greenback to make a bear market rally in June and then roll over after the first week of July.  If the buck bounces over the next few weeks, watch to see if there’s a moving average or chart pattern that supports the rally.  Also, observe how it reacts to technical resistance on the way up.  If the rally starts to erode once July starts, it could be a good clue that the next downdraft in the dollar has begun.

What Say the Charts?

On the daily timeframe, a Death Cross occurred on May 26th when the 50-day Moving Average closed below the 200-day Moving Average.  This is a well-known sell signal.  The last time it occurred was fourteen months ago and the greenback dropped for several more weeks afterwards.

More important than this Moving Average crossover signal, though, is the obvious bearish price pattern unfolding right now.  The US dollar index posted a multi-year high of 103.82 on January 3rd and then dropped to a low of 99.23 on February 2nd.  A bounce to a lower high of 102.26 on March 2nd was followed by a decline to a lower low of 98.85 on March 27th.

Once the Groundhog’s Day low was broken, the greenback had officially established a lower low and a lower high.  This downward trend has been confirmed as additional lower bounce highs and lower corrective lows have followed.  Until this pattern is broken, consider the US dollar to be in a well-defined downtrend on the daily chart.

On the weekly timeframe, the US dollar cracked important trend line support at the end of April.  The trend line was drawn across the May 3, 2016 low of 91.91, which set the low for the year, and the June 23, 2016 correction low of 93.01 that was established in reaction to the Brexit vote.

The US dollar index tested this trend line in August and September and then recovered.  The trend line really proved its worth during the Presidential election when it made a knee-jerk reaction and collapsed to a one month low, tagged the uptrend line, and then exploded higher just hours later.  The trend line confirmed its credibility.

After undercutting the Groundhog’s Day low on March 27th and touching the weekly trend line again, the buck bounced.  This was not a surprise.

The surprise came a month later when the bounce faded and the greenback opened ‘gap down’ on April 24th.  The US dollar had all week to recover the trend line, but it never did.  It has been below the trend line since.

Interestingly, the brief bounce into the May 11th high took the greenback right up to the bottom of the trend line and it immediately shrank back from it.  This confirms a classic charting rule: Technical support, once it has been broken, becomes technical resistance.

On the monthly timeframe, there are three ways that a case can be made that the multi-year bull market in the US dollar index has suffered a severe blow, maybe even come to an end.

First, there’s the Wash & Rinse sell pattern that took place.  The greenback initially had a double top established between the March 2015 high of 100.39 and the December 2015 high of 100.51.  The buck ran through this top back in November and negated the bearish pattern.  Just a couple of months later, the greenback reversed from making a new multi-year high to closing back under the 2015 top.  This failed breakout has bearish implications.

The second negative on the monthly timeframe occurred at the same time that the Wash & Rinse sell pattern was established.  The Fibonacci .618 retracement of the entire decline from the July 2001 fifteen-year high of 121.02 to the March 2008 multi-decade low of 70.69 was located at 101.79.  This important technical resistance was surpassed in November.  But like a junkyard dog running at full speed without regard to the chain around its neck and the stake firmly in the ground, the buck abruptly stalled out just a couple of pennies higher and was quickly jerked back down.  It appears that the Fibonacci .618 boundary is working.

Finally, the greenback finished the month of May below the 12-month Moving Average of its closing price.  Now, this bearish trend change signal does not always work.  Nothing ever does.  But you can see that a majority of the time it has led to lower prices in the months ahead or at least a multi-month consolidation period.  It rarely pays to bet against this bearish trend change signal.

Different Shades of Grey

The US dollar index is an unequally-weighted basket of six different currencies.  The biggest weighting is toward the Euro currency, which makes up 57.6% of the index’s value.  The rest of the currencies that make up the index are the Japanese yen (13.6%), British pound (11.9%), Canadian dollar (9.1%), Swedish krona (4.2%), and Swiss franc (3.6%).

You can short the US dollar index, of course, but you can also get more specific and bet on the long side of one single currency against the greenback.  There are several to choose from, but I will mention just a few of your choices here.

Since it has the most weighting against the US dollar index, the Euro currency might be a good instrument of choice for dollar bears.  It will run the closest to being a mirror image of the US dollar index.  More importantly, it has significantly more liquidity than the US dollar index does.  In the futures markets, the Euro currently has open interest of just over 451,000 contracts and the US dollar index has open interest of just over 84,000 contracts.  The bullish Euro currency ETF (FXE) has volume of just over 1,150,000 and the bearish US dollar ETF (UDN) has volume of just over 21,000.  Liquidity matters!

Although it only accounts for 13.6% of the US dollar index weighting, the Japanese yen is another currency worth consideration.  It’s a little less correlated to the US dollar index than the Euro currency is, but it’s still highly liquid and traditionally a great currency for trend followers.  In January the yen signaled a bullish trend change via the 20-month Moving Average, which has an admirable track record, and has stayed close to it since.  If you aren’t long the yen yet, there’s still time to hop on board that train.

Earlier in the post, I mentioned that the US dollar’s trend has a strong inverse correlation to commodities.  This also extends to commodity dollars like the Canadian dollar, Australian dollar, and New Zealand dollar.  These are the currencies of commodity-producing countries and are strongly linked to commodity price trends.  Therefore, a decline in the US dollar could be the rising tide that finally lifts these currencies from their multi-year slump.

Choose Your Weapon

All of the currencies can be traded in forex, of course. If you already have a forex broker and a platform you’re happy with, great.  You already know what to do, so just keep on keepin’ on.  But many currencies can also be traded via futures contracts or ETFs as well.  Make sure you think it through before jumping in.

I’m a bit biased because I started my trading career in the futures markets.  That being said, one of the things that I really like about currency futures contracts is that it offers tons of leverage (much more than you really need), but with regulations that they can’t seem to bother with in forex.

I recall a time when I had a stop order filled in forex on a Swedish Krona.  The slippage on the fill was bad enough, but I was really livid when I found out that some of the other banks I talked to didn’t even show that the price went low enough to trigger my stop in the first place!  When I complained to the bank desk I was trading at, they said, “Hey, we’re doing you a favor by even taking an order for a $7 million dollar position in the first place.  You can’t expect to get the same kind of fills as our institutional traders.”  That was the last time that I traded currencies in forex.  At least in the futures market, I know the price range is the same for everybody.

If you’re a smaller trader or new to currency trading, I suggest you steer away from forex and futures contracts for now and look at the ETFs.  You don’t get the same amount of leverage, but hey, you don’t need to mess around with high leverage when you’re new to trading or operating with a small stake.  Your goal should be to focus on following your trading process and preserving capital.

Once you have a few years of trading experience under your belt and your trading capital has grown, then you can proceed to…

Focus on following your trading process and preserving capital!

Perhaps you’ve heard the Zen saying that goes, “Before Enlightenment chop wood, carry water. After enlightenment chop wood, carry water.”

Well, maybe we should have a trader’s saying that goes, “Before Experience follow trade rules, manage risk. After Experience follow trade rules, manage risk.”

You will find that the successful traders don’t use nearly that much leverage, either.  Also, the pros don’t focus on how much money they can make; they focus on how much money they can lose.  Their time and energy is spent on monitoring their trading systems and managing risk, not trying to figure out how to turn a $10k account into $10 million in twelve months of day trading.

It’s a good possibility that the multi-year run higher in the US dollar has finally ended.  It’s time for traders to get loaded for bear.  Make sure you’ve chosen the right weapon (forex, futures, ETFs, options, etc.), you have enough ammo (risk size determines how many shots you can take), and then exercise patience (wait for the right setup and a trade signal).  Remember: A good hunter doesn’t chase; he waits.

 


More Articles by Jason Pearce:

Equities: US Against the World

Profiting From Failure: The Wash & Rinse Trade, Part II

Profiting From Failure: The Wash & Rinse Trade, Part I

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

 

Continue Reading...

by:  Brynne Kelly    June 7, 2017

Quick Oil Market Stats:

Just a short note regarding this week’s Inventory data.

Inventory Change – Total Build of +9.3

This is an impatient market unwilling to take it’s eye off a bearish narrative and this week’s build in inventory plays right in to that.

Below are a few charts to get a sense of where we are versus this same week in prior years.

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Yearly Comparisons

EIA, Crude Oil, Oil Price Curve, Inventory Comparison

Oil, gasoline and distillate inventories are at similar levels compared to the same inventory week last year, with production quite a bit higher.  By comparison, the entire price curve has shifted $6.00 lower.  How is this year different?

Prior Year June through end of September Inventory Changes

Looking at inventory changes from June – September over the last 3 years, it seems as though the market is bracing for something closer to a 2015 scenario.  This time last year the market was looking forward to some sort of action by OPEC.  Today, the market is eyeing the END of OPEC’s production cuts.

The bearish sentiment this has created is unrelenting and easily fueled by weekly data that once again failed to provide a clear sign that the worst is behind us.  In the last 2 months, total inventories have drawn-down almost 30 million barrels including this week’s build.

We are only a short time into a new era that includes the ability to export oil.  It’s important to remember that the timing of exports from week to week will be volatile. History is still being fashioned.  At this point the market seems unwilling to trust the noise created by the ups and downs of reported exports from one week to the next.

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