Pairs Trading Gold and Oil
Jan 6, 2017
By: Sage Anderson
While 2016 fades in the rear-view mirror, market trends from last year will continue to play an important role in 2017. Therefore, analyzing and understanding data from 2016 may help get your portfolio best positioned for the new trading year.
For example, both gold and crude oil experienced significant (and possibly unexpected) price action during 2016.
In fact, it wasn't that long ago that a slide in crude oil threatened to take down worldwide equity prices when prices slumped below $30/barrel in February 2016.
After bouncing ever-so-slightly due to reduced global production (improving supply/demand equation), crude oil truly took flight when OPEC started discussing (and ultimately agreeing upon) a coordinated supply cut. Due in large part to this OPEC activity, crude oil marked its biggest annual gain since 2009 as West Texas Intermediate (WTI) rose 45% during 2016.
With the oil cartel's production cuts scheduled to kick off at the start of 2017, the direction of oil prices in early 2017 will be largely dictated by OPEC's adherence to the deal. Worldwide oil production data for January of 2017 should be available in early February.
While gold prices followed a similar upward trend alongside crude oil for the bulk of 2016, this well-known commodity reversed course dramatically during the last couple months of last year. The early bullish trend in gold was likely due to the US Federal Reserve's decision to hold off on an interest rate hike throughout the first three-quarters of the year.
Likewise, the drop in gold prices at the end of 2016 was related to expectations (later proven correct) that the US Federal Reserve would raise rates at their December meeting. With the Fed guiding for three more increases in benchmark interest rates in 2017, gold prices movement in 2017 will hinge to a great degree on the actions of the US central bank.
Generally speaking, rising interest rates catalyze a strengthening US Dollar, which in turn weakens gold. However, gold prices can also be affected by perceived threats to the global economy (i.e. "flight to safety) and other factors.
It's possible you've already mapped out a plan for 2017 in crude oil and/or gold that fits your existing portfolio, outlook, and risk profile. However, if you are still considering new ideas for the coming year, a recent episode of Closing the Gap - Futures Edition may be a great place to start.
On the show, hosts Tom Sosnoff, Tony Battista, and futures expert Pete Mulmat outline a pairs trading idea that involves crude oil and gold futures. While the show includes a wide-ranging discussion on both commodities, the crux of the rational for the the trade involves the "Gold/Crude Ratio."
Obviously, picking the direction of either commodity over the course of 2017 is extremely difficult. That's why the trade detailed on Closing the Gap is deployed using a reference point that measures the historical relationship between the prices of the two commodities.
The Gold/Crude Ratio is calculated by dividing the current price of crude oil into the current price of gold. With gold currently trading about $1152/ounce and crude oil trading $54/barrel, that means the Gold/Crude Ratio currently stands at roughly 21 (1152/54 = 21).
As you can see in the graphic below, the current value of the Gold/Crude Ratio is somewhat depressed compared to recent history:
According to the above data, traders expecting a reversal in the Gold/Crude ratio could express their opinion by purchasing gold futures and simultaneously selling crude oil futures. Obviously, the ratio goes higher (i.e. the trade wins) when either gold prices move higher, when oil prices move lower, or both.
For a complete explanation of this trade we hope you'll take the time to review the full episode of Closing the Gap - Futures Edition focused on pairs trading these two global commodities.
While this trade structure may not fit your current portfolio and/or risk profile, it's possible that ever-changing market conditions may make it look more favorable at some point in the future.
If you have any questions about futures or any other trading topic, we hope you'll reach out at firstname.lastname@example.org.
In the meantime, we wish you all the best for a great new year!
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.
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