Trading Forex By Watching Commodities

06/10/2010 12:01 am EST

Focus: FOREX

Sam Evans

Instructor, Online Trading Academy

As we all know, the forex markets offer a variety of interesting and unique opportunities. While I personally trade a variety of asset classes, including stock index futures and commodities, as well as forex, my discipline and technical approach to each of these markets remains the same. I look for low-risk, high-probability opportunities, respecting the governing laws of supply and demand at all times.

Price is simply price, no matter what we are looking at, and it will always be the greatest leading indicator of them all. However, it should also be understood that each specific market available to trade also comes with its very own characteristics and nuances, which can aid the skilled and disciplined market speculator if used logically, and more importantly, objectively.

When it comes to forex trading, we can use cross pair analysis to look for trades that combine weak and strong currencies, and we have the added benefit of a highly liquid environment that operates a full 24 hours a day. There are many other advantages that I could talk about, too, but for the purpose of today's article, I would like to revisit the role of commodity prices and how they relate specifically to a handful of world currencies. There are some very powerful positive and negative correlations in these markets, and again, if used objectively, they can aid the trader in their consistency and overall probability of success. However, we also know that everything works until it doesn't from time to time! The consistent trader needs to always eliminate emotion and ego from the decision making process in these instances, and typically, all that is required is a little bit of common sense and planning to fix the problem. Let's look specifically to the Australian dollar and gold in this instance.

As many of you may well know, the Australian dollar is classed as a "commodity currency." This stems from its unique and powerful relationship with gold, as seen on the charts below:

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Figure 1

In this daily chart dating from June 2009 until the middle of April 2010, we can clearly see a consistent and clear upwards trend in the AUD/USD currency pair. We can also see similar price action in the gold market during the same period of time:

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Figure 2

The duality of price action between gold and the aussie dollar is explained by the simple fact that Australia is a major worldwide producer of gold. When demand for gold is on the rise, buyers need to in turn convert their cash into Australian dollars to purchase the physical products, thus creating a natural demand for the currency and increasing its price. Likewise, when more are selling gold and creating supply, this also pushes a greater supply of Australian dollars into the market and typically results in a fall in the price of the currency.

While this powerful relationship can be implemented and explored for use in trading techniques, it should also be noted that as traders, we should never become too reliant on these fundamental correlations alone as a reason for taking a position. Sometime these intermarket relationships crumble, too, which could cost amateur traders dearly if they are not prepared at all times.

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Let's take a look at this principle in action:

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Figure 3

As we can see from AUD/USD, since the middle of April 2010, we have witnessed a sharp selloff in the pairing, moving from highs of 0.9380 to as low as testing the 0.8080 area. In the very same period of time, however, we have not seen the same thing happening to gold:

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Figure 4

In quite the opposite fashion, gold continued its rise to make new highs in early May. If you had been relying on the previous positive correlation between gold and the AUD/USD to determine your trading decisions, you could have potentially lost a lot of money. So why has this happened? Well, as you know, I am a technical trader, and from this perspective, there are good reasons why these moves have happened, but we can also look to the simple logic behind the fundamentals for a clue as well.

Demand for gold is created for key reasons. The first is for its use as an outright commodity in the manufacturing process. When economies are growing, there is an increase in production, which creates a demand for gold and pushes the AUD/USD higher as well. The second reason for demand for gold is for its status as a "safe haven" in times of uncertainty. Bullion will always be a form of "real" money, and investors adopt this understanding by putting their capital into gold when the markets are failing. During this scenario, mindsets change from greed to fear, meaning that while demand for gold will continue during a flight to quality, riskier assets like stocks and higher-yielding currencies like the Australian dollar will be ditched, hence, unwinding all previous correlations. Gold loses its status as an outright commodity and evolves into a hedging vehicle.

I have met countless traders over the years who have been burned by their lack of flexibility in these matters, and I always teach my students to remain as objective in their trading as possible to avoid the same mistakes. There is no such thing as a leading indicator for price, and we need to accept this. The best way to approach the market is to always keep things simple and to focus on what the market is telling you right now, rather than what it showed you in the past.

By Sam Evans, instructor, Online Trading Academy

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