At tastytrade, we often refer to the process of generating a trading idea as "building an assumption."
A key component when building trading assumptions is of course market awareness - which involves an understanding of what moves asset prices as well as an ability to recognize correlations that exist in the market. Another input is, of course, the innate curiosity required to uncover and capitalize on potential opportunities.
tastytrade produces plenty of daily (and archived) trading-related videos that can help new and veteran traders improve their market awareness - all of which can ultimately help catalyze idea generation.
If you want to gain a better understanding of what "building an assumption" means at tastytrade, we invite you to review an episode of From Theory to Practice with the always dynamic Dr. James Schultz.
If you're ready to jump straight into the primary focus of today's post, then strap on your seat belt and get ready to learn more about "building an assumption" in currency futures!
A recent episode of Closing the Gap - Futures Edition introduces both "metal" and "petro" currency futures and walks viewers through the process of building an assumption and transforming it into a deployable trade.
The Australian Dollar (/6A) is often referred to as a "metals currency" because of its strong correlation to copper and gold. Both of these commodities are mined extensively Down Under and contribute extensively to the country's GDP. When demand for commodities such as these (as well as coal and iron ore) is booming, Australia's economy tends to outperform, and their currency will likewise appreciate.
The Canadian Dollar (/6C) on the other hand is often referred to as a "petro currency" because of that country's strong ties to the oil and gas industry. When the price of crude oil is rising, the prospects for Canada's economy also start to lift off.
On this episode of Closing the Gap - Futures Edition, tastytrade's resident futures expert, Pete Mulmat, provides some valuable insight on recent trading activity in both Australian Dollar and Canadian Dollar futures trading.
As illustrated in the chart below, the Canadian Dollar tends to follow the direction of crude oil. Given the recent the recent supply cut negotiated by OPEC and non-OPEC countries, there's reason to believe that the Canadian Dollar could strengthen in the near-term as the price of crude oil rises:
As you can see from the above, the Canadian Dollar has fallen much further than crude oil in recent months, and could become a relative outperformer if oil holds these prices or goes higher.
Looking at the Australian Dollar, there's reason to believe that the currency may face headwinds over the course of 2017. With inflation near 19-year lows in Australia, it's looking more likely that rates could get cut in Australia (or at least stand still) this year instead of moving higher.
Comparing that expectation against the US Federal Reserve's guidance for three potential rate hikes in the US this year means that relative to the US Dollar, the Australian Dollar could weaken in 2017.
Putting these assumptions together, the Closing the Gap - Futures Edition team considered executing a pairs trade involving the following futures positions:
long 1 contract of the Canadian Dollar (/C)
short 1 contract of the Australian Dollar (/A)
For the best possible understanding of how the long Canadian Dollar versus short Australian Dollar trading assumption was built, we recommend you watch the entire episode of Closing the Gap - Futures Edition when your schedule allows.
It's entirely possible that your own outlook for these currency futures is different than those discussed on the show. While this specific trading structure may not fit your current trading strategy or risk profile, it's possible that another pairs trade involving foreign currencies futures you follow closely may become attractive at a later date.
If you want to learn more about building assumptions related to volatility trading, a past episode of TastyBites may also be of interest.
If you have any questions about any of the material covered in this post we hope you'll follow up at firstname.lastname@example.org.
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.