Many traders look for correlation strategies where either a
trend in some security translates into a trend in another, or the disconnection
of trends between two normally correlated securities results in a potential
trade opportunity as the prices re-converge. Much of the most popular information
out there at the moment is on currency correlations, but possible trade ideas
are not just confined to products within the same asset class. Indeed, in the
first of a series of posts looking at how oil trades in relation to other
products, I’ll be taking a general look at the relationship between oil and
equities.
To begin with, a quick
overview of the causes of oil price changes is necessary to give some context
to the changing relationship between oil and equities. On a fundamental level,
there are four possible causes of oil price changes stemming from changing supply and demand, with the effect on
equities outlined on the table below:
Increasing oil prices can be
caused by either higher demand or lower supply and the cause behind the oil
price change will determine the effect on equities and thus the correlation
between the two. In the case of higher demand the cause behind the rise in
prices is higher spending across the economy, thus increasing corporate profits
as well. In the case lower supply, higher costs to consumer’s fuel bills will
likely reduce disposable income and thus cause corporate profits to fall. On
the other hand lower oil prices could be caused by either lower demand, and
thus lower spending and lower corporate profits, or higher supply and thus
lower costs and higher corporate profits. Obviously these are general cases
which have their own contradictions in the long-term, such as increasing fuel efficiency
decreasing oil demand while increasing disposable income, but such examples
tend not to distort short-term correlations.
To demonstrate the changing relationship between oil and
equities over 2013, the two charts below show week on week price changes of the
S&P 500 US equities index and Brent as well as the 10 day correlation
between the two price levels. In the first marked section from mid-January to
the beginning of March, Brent and the S&P 500 mostly moved in tandem with
each other. For a period during March however, the two moved away from each
other as the S&P 500 increased while oil prices fell. Followers of markets
will remember that the first time period was characterised by
increasing economic confidence to begin with, which led to higher demand
expectations for both equities and oil, but was then followed by economic news
failing to meet expectations as both prices fell. In early March however both
demand forecast cuts by international agencies and further problems in the euro
area cut expected global oil demand and thus prices for Brent, while US
equities continued to advance as conditions there were generally positive.
How to profit from the
correlation
While many other factors come into play, particularly in
today’s climate of quantitative easing, the correlation between US equities and
oil begins to show the potential of correlation strategies in creating
profitable trades. Take the point marked A on the graph below as an example, oil
and equity had been highly correlated on economic confidence, but some worse
than expected economic data releases resulted in falling US equities and oil
prices. In this case shorting both on those announcements would have been
profitable strategy.
Next week this series of posts will take a look at how oil
prices are correlated with currencies, so check back soon.
