Cross-market analysis

Cross-market analysis and market correlations

Cross-market analysis is a valuable tool for traders aiming to develop a well-rounded view of a financial landscape. By comparing different financial markets, such as forex, precious metals, and other commodities, traders can uncover hidden opportunities and manage their risks more efficiently.

At its core, a market correlation shows how two markets move in relation to each other. If they move together (positive correlation) or in opposite directions (negative correlation), it can indicate underlying economic trends. For example, the usual inverse correlation between the USD and gold prices reflects investor preferences for safety during uncertain times.

The connection between crude oil prices and the Canadian dollar (CAD) is another example of market correlation. Since Canada's economy relies heavily on oil exports, CAD often moves in response to oil price changes. Traders can use known correlations like these to predict market movements.

How to trade market correlations: Crude oil and CAD

Let’s look at crude oil and the Canadian dollar (CAD) as an example.

Imagine global crude oil prices rise sharply from $50 to $70 per barrel over three months, due to higher demand and geopolitical tensions.

Since Canada is a major oil exporter, this increase would likely strengthen the CAD and drive its value up. This would be because if investors expect higher earnings from oil exports they are likely to buy more CAD assets.

The following example demonstrates how someone might set up a trade.

Before the oil price increase: 1 USD = 1.30 CAD

After the oil price increase: 1 USD = 1.25 CAD

Assuming you expect oil prices to rise from $50 to $70 per barrel, which would strengthen the CAD against the dollar, you would decide to enter a long position in CAD/USD at 1.25, expecting the CAD to strengthen.

Entry point: 1 USD = 1.25 CAD

Direction of the position: Long on CAD/USD, expecting the CAD to appreciate due to rising oil prices

Stop loss order: If you enter the trade at 1.25 (1 USD = 1.25 CAD), a 2% move against your position would be to 1.275. Considering you are long on CAD/USD, a rise in this ratio means CAD is weakening.

A stop loss order is placed to minimise potential losses if the market moves against your position. To set a stop loss order, determine an acceptable level of loss based on your trading capital and risk management strategy. Considering the volatility in the forex and commodity markets, a 2-3% move against your position might be a reasonable threshold for a stop loss in this scenario.

Incorporating risk management strategies is crucial for traders to protect their investments, especially in volatile markets like those for crude oil and currency pairs like CAD/USD.

Role of fundamental analysis and economic indicators

Fundamental analysis involves evaluating economic indicators, financial statements, and other qualitative and quantitative factors. In cross-market analysis, understanding how interest rate decisions affect currency values, or how geopolitical events influence commodity prices, is crucial.

Pay attention to reports on GDP growth, employment rates, consumer price indices, and central bank announcements. For example, rising interest rates in the US might strengthen the USD and simultaneously pressure commodity prices.

The Fed’s decision to increase interest rates as a measure to combat rising inflation in the US usually signals a stronger economy. Higher interest rates make the USD more attractive to yield-seeking investors, leading to an increase in the value of the USD.

How to trade market correlations: Gold and USD

Let’s look at gold and USD as another example of market correlation and how to trade them using fundamental analysis.

Higher yields on US treasuries and other interest-bearing assets attract more foreign capital, driving up the value of the USD against other currencies.

Commodities, including gold, are priced in USD. As the USD strengthens, commodities become more expensive in other currencies, potentially reducing demand and causing prices to drop. Gold, often seen as a safe haven and a hedge against inflation, may experience downward pressure as investors shift towards yield-bearing assets.

Assuming you're monitoring fundamental changes and expect the dual effect of rising US interest rates, you decide to implement a trading strategy that involves going long on USD against a basket of currencies and short on gold.

Long USD position:

• Entry point: Shortly after the interest rate announcement, assuming EUR/USD is at 1.15, anticipating the USD to appreciate
• Stop loss order: Set at 1.1450, protecting against unexpected market moves that could devalue the USD
• Take profit order: Set at 1.1600, aiming to lock in profits from the USD appreciation

Short gold position:

• Entry point: If gold is trading at $1850 per ounce at the time of the Fed's announcement, you enter a short position, anticipating a decrease in price
• Stop loss order: Set at $1865, limiting losses if gold prices unexpectedly rise
• Take profit order: Set at $1820, securing profits from the expected drop in gold price

Technical indicators in cross-market analysis

Applying technical indicators across different markets can highlight patterns and confirm trends, making them valuable tools for cross-market analysis.

The MACD is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. Traders use the MACD to identify potential buy or sell signals, which are indicated by the MACD line crossing above or below the signal line.

As mentioned before, forex and commodity markets often show strong correlations, especially between the USD and gold prices. Generally, a stronger USD leads to lower gold prices and vice versa. Let's use the MACD indicator to analyse these two markets simultaneously for trading opportunities.

Assume the MACD on the USD/JPY currency pair shows a bullish crossover, indicating potential USD strength. Simultaneously, the MACD on gold prices shows a bearish crossover, suggesting a potential decline in gold prices. These simultaneous MACD signals align with the typical negative correlation between a strong USD and gold prices, providing a cross-market confirmation of the trend.

Based on the MACD crossover signals and the known correlation, a trader can decide to take two actions:

1. Go long on USD/JPY, anticipating USD to strengthen
2. Short gold, expecting gold prices to drop due to the stronger USD

Traders should combine technical and fundamental tools in their cross-market analysis to get a more comprehensive view of the markets and predict market movements more accurately. This will help you to spot ideal entry and exit points, increasing chances of success and enhancing your risk managements strategies.

The numerical examples in this article are for illustrative purposes only and don’t represent actual market data or predictions. Please use real-time market data and conduct your analysis before making any trading decisions.