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Oct 27, 2015

Back to the Futures: Oil vs. Canadian Dollar

By:Sage Anderson

The tastytrade financial network is proud to have the CME Group as a sponsor for one of its most closely-followed programs - Closing the Gap: Futures Edition.

Today on the blog, we are happy to present a recent episode from this series that focuses on crude oil and the Canadian dollar.

Having suffered a price decrease of roughly 48% over the last 12 months, crude oil has been a major lever in world equity markets throughout 2015.

Oil is an essential part of the world economy, so a significant increase or decrease in the commodity's price has wide ranging impacts on people, companies, and governments.

On a recent episode of Closing the Gap: Futures Edition, hosts Tom Sosnoff, Tony Battista, and Pete Mulmat discuss not only crude oil futures, but also layer in a foreign exchange (FX) component with an examination of oil’s relationship to the Canadian dollar.

The Canadian dollar, often referred to as the "loonie”, has lost approximately 12% in value over the course of the last 12 months (as compared to 48% for crude oil).

The chart below shows the movement of the crude oil and loonie prices over the last 5 years:

As the hosts note on the show, there has long been a strong correlation between oil and the loonie. In fact, a 10-year analysis of the correlation between crude oil and loonie prices (against the US Dollar) reveals there is a 0.78 relationship.

Given that a score of one would indicate a perfectly correlated relationship, crude oil and the loonie are without question closely tied at the hip in terms of price movements (as reinforced in the chart above).

The high positive correlation between the Canadian/US Dollar exchange rate and crude oil is due, in large part, to the high proportion of foreign receipts that Canada receives for the sale of crude products - much of which is paid in US dollars.

The above really hits home when one considers that approximately 97% of crude oil exported by Canada is imported into the United States. That means changes in the price and export volume of Canadian oil directly impacts the flow of US dollars into the country.

Thinking in terms of supply and demand, that means that when Canada is receiving a high price for their oil they are also receiving a large volume of US Dollars, making their own currency relatively more scarce (and valuable). Alternatively, when the price of crude is low and fewer American dollars are entering Canada, the relative proportion of Canadian Dollars in circulation goes up, making the price go down.

Pete highlights on the show that in recent trading, the link between crude and some of the oil currencies (including the Canadian Dollar) has experienced a breakdown. As an example, Pete mentions that the current correlation between crude oil and the Canadian/US Dollar exchange rate has been around .18 over the last month (as compared to the 10-year correlation of .78).

This observation is where the "rubber meets the road" in terms of trading opportunity. As Tom states on the episode, "when 80% correlation goes to 18% correlation, that's an interesting trade."

Pete moves the discussion to another level when he introduces a trade idea that capitalizes on the breakdown in correlation between crude oil and the loonie.

It's important to note here that Pete developed this trade idea in part using Implied Volatility Rank, or IVR. The IVR metric is a tastytrade innovation that tells us whether implied volatility is high or low in a specific underlying based on the past year of IV data.

For example, if XYZ has had an IV between 30 and 60 over the past year and IV is currently at 45, XYZ would have an IV rank of 50%.

As Pete points out, the current implied volatility ranks for crude oil and the loonie suggest that an excellent trading opportunity may exist between these two products.

Pete goes on to detail a pairs trade structure that involves buying two Canadian Dollar futures contracts (IVR ~9%) versus selling one contract of WTI Crude futures (IVR ~47%). Given the historically strong correlation between these products, current implied volatility levels offer a great opportunity to offset risk against the other - low IVR (loonie) versus high IVR (oil).

That type of risk arbitrage is the precise structure we are trying to identify on a regular basis when trading volatility.  

The details of this trade are outlined in the slide below:

We encourage you to watch the entire episode of Closing the Gap: Futures Edition focusing on the relationship between crude oil and the Canadian Dollar when your schedule allows.

The guys discuss not only Pete's suggested trade in greater detail, but also the optimal conditions to deploy it.

If you have any questions or feedback on this show please don't hesitate to send us your thoughts at support@tastytrade.com.

We look forward to hearing from you!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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