• Jan

Trading the crash cycle of crude oil





This article will focus specifically on trading the crash cycle in crude oil, an excessively bearish move with a significant % change in crude price in a short amount of time. Such moves are usually the result of large supply and demand imbalance, either initiated by the supply glut where the price of oil drops due to a sudden flood of crude supply on the global market, or the other side of the equation- the demand shock where the global demand for crude all of the sudden drops significantly, usually due to the world-wide economic crisis.

Such a drastic change in conditions, which usually last approximately 6-15 months before the crude price recovers, allows the trader to trade in the direction of a strong shift of crude price for a while.



The difficulty however is in finding the real clue on why the down cycle has begun, and in some cases it will be clearer while in others it might not be. This requires decent wide knowledge (research historically) on how financial markets respond across assets during the economic crisis, or how especially major oil-producing nations work in relationship to each other such as US / Russia / Saudis / Iran / OPEC and relationships between those countries, which often plays a role on the downturn cycle of crude price.

Not just in terms of potential supply cut / expansion plans that might or might not fail or proceed but as well the overall political cooperation between governments of those key crude producing countries. Usually politically there is a 10 year cycle, where the crude producing countries either are lined with the US or against it politically, which plays often major role on the correspondent moves of crude price, once in a while. But the focus of the article will not be the political or structural component, but instead more practical relationship between currencies and equities of energy stocks in relation to bear cycle of crude.


This article will touch upon the relationship of different financial instruments and their reaction to the crude oil price shocks, but the focus will mainly be on instruments that are highly liquid/leveraged and can be practically traded by a daytrader. Bonds and some other instruments will be excluded since they are mostly not a good choice of day trading vehicle for smaller capitalized traders.





There are few side concepts in the oil industry that trader could study to better understand the movements of crude before the actual cycle starts (and how each of those contributes to mid term moves of crude oil today):


-Key strong players within the industry and their corporations (Rothschild / Rockefeller companies and its offspring, Exxon, Mobile, Dutch Shell, ...). Often Rockefellers' offspring companies are in very tight collaboration with the US government which makes tracking of their moves in terms of supply and demand output important or the moves of both families in terms of investing decisions a thing to follow (especially the investment fund of Rothschilds).

Since a lot of this can be related to inside information or very costly information for retailer to gather (more accessible to hedge fund), it is ideal that focus should be to gather and study historical information instead to layer how those companies / families responded around key strong cycles of crude oil moves.


-Internal political decisions of Iran / Iraq / Qatar / Egypt (and their cycles) as they play an important role on price moves from time to time, mainly those come into play every once a 10 years when there is either pro-western or anti-western shift in the internal politics of Iran, which then impacts on how much crude is Iran allowed to input or not to the international market. Especially important if sanctions are imposed, it can provide a decent boost to crude price for a certain period of time, a small bullish cycle.

Egypt played important role in 70s, as it did Iran, and later on Qatar, and then 15 years later cycle repeated across some of those countries.


-The role of the US administration and their talks with Saudi Arabia. This is a heavily over-looked subject that rarely any trader tracks and yet has perhaps the strongest negative impact on potential supply gluts of crude. (70s and 2014)


-Independence of the US oil industry and its progression over last 40 years (after Nixons plan to place US as self-sufficient producer and to never allow situation of demand glut to repeat from 70s).



Again above are outlined just core pointers, this is up to interested individual to dig deeper.










The cost of production (per barrel) can be misleading indicator




One thing to keep in mind is that production price per barrel as shown in the image above is highly relative or slightly irrelevant to how markets price in equity/currency moves of those countries if the price of crude oil suffers large fall.


It is very common to see that macro participant misjudge the situation by thinking that if the price of oil (even after large drop) is still above the production cost of the country does not pose a major risk to countries financial system or oil industry. It is not a practical way to use the price of production per barrel as a leading indicator of how should country withstand the fall of crude on its equities or currency. Rather other secondary variables define how should the currency and equity market respond in such case (remember, isolating variables is not ideal, its better to stack multiple variables in the same direction to achieve really strong trend):



-Size of external debt denominated in dollars


The more debt that country has or specific oil-producing companies have denominated in foreign currency (USD or EUR), the more exposed they are to drop in oil prices. As the price of crude drops the income that those countries gathered from selling oil internationally in USD drops as well, which creates a situation of harder to finance the debt (as revenues decrease) and as well putting pressure on layoffs or supply cuts (indebted energy companies might be forced to close wells).

The size of debt measured in debt to GDP ratio is what is the average determining factor. Emerging market producing nations (such as Nigeria) are more prone to having larger USD denominated debts compared to more developed nations (such as the UK), which determines how creditworthy condition of country drops amid crude price shock. The more debt that country has in its currency (internal) the better it can withstand the shock, which is especially reflected in currency performance in such cases.



-Overall productive capacity of economy in terms of % of GDP


The higher the productive capacity (real growth, low inflation and diversification of economy), the more cushion the country has to withstand the drop in crude prices if the country is a major oil producer. This means the more diversified the economy is away from the crude the better (in terms of other industries and revenues), and the smaller the budget deficit is the better as the country can afford to implement austerity to prevent the shortfall.

An example of a more diversified higher resistant economy would be the UK as a smaller scale crude producer and the opposite case of Venezuela as much less diversified but larger scale producer. That kind of opposites in the structure of the economy plays a major role in how especially equities of energy companies perform during the fall of crude prices.

Growth of economy is directly correlated with the variable above (size of external debt) since the higher the growth rate of economy and the lower the debt the better. Or the higher the debt and the lower the growth the worse.



-Capital cushion of FX reserves (Norway)


Norway is a good example of a country that is relatively well-positioned into any crude oil shocks. Even though that the production price of crude in Norway is by no means low, the capital cushion of Norway's largest investment fund is so wast relative to the size of the economy that the default risk of the country or larger companies by itself is very low.

This shines a good light that using production cost per barrel is highly subjective or relative since certain counter variables can quickly re-scale the equation of who is and who is potentially not in trouble if crude oil suffers a large fall in price.

This also plays a large difference in currency performance for example, where NOK (Norwegian krona) usually suffers much less of a decline in crude price drop relative to some other country such as Russia which does not have wast FX reserves (relative to the size of the economy in GDP). Which is one of the reasons why the drop in Russian ruble in 2014 and 2020 was that much stronger, relative to the Norwegian krona.



-The structure of oil producers in terms of sea pumping, fracking, etc...


This mainly applies to equity asset performance, certain methods of oil drilling are more expensive or even negative without financing (fracking) and certain are less expensive and more profitable (mixed production of Exxon for example).

This plays then a major role in which equities take a stronger % downturn in such conditions and which take less. If a trader is initiating positions on the energy company stocks it is worthy to note what kind of production is a company engaged in to better define how strong could the trend of the move progress. The costlier the production accessing method the stronger the potential drop.



-Size of the company (market cap and the number of wells in operation):


The general rule is the larger the company the more capital it has on hand, the longer it can afford to withstand the fall of crude price, and the more it can "open the pipes" to supply the market with as much crude as possible to create as much income in conditions when the price per barrel is dropping.

Smaller producers are often in much tougher situations and have to either close the production completely (to maintain expenses as they go too negative) or they have to shut all remaining production but the wells that are operating at lower costs.

The larger the company and the more capital it has on hand the better. As well there is secondary rule, big companies are generally protected by the state as their liquidation would pose too large risk to entire economy and safety of supply chains, which makes higher cap companies "bucketed" more likely if the price of equity / stock drops substentially.



-The power of financial system to finance loans of leveraged oil producing companies


It is not to be underestimated how important role the leading financial system plays in a role to finance high-cost oil-producing companies. The US especially (and UK to some extent) can finance the shale industry with much higher debt participation than any other country (since it has the reserve currency and wast financial system), which makes chances of defaults lower even if production costs per barrel are that much higher relative to other countries.

This especially holds true if the government decides to step in the middle to actively provide the loans to companies amid the crude price crash, which is something that not every country can afford. This mostly plays a role over a long time horizon, however, it does play a role as well in the midterm horizon to higher capitalized crude producers in the US energy sector as they can be bailed out relatively easy.



In the crash cycle itself for trader to extract the value in terms of trading the currency or equities as described on article within the right direction, it is absolute key to be objective in assessing the situation for each individual country and to not let your subjective (political or other) views get in the way of perception.

When it comes to trading, there is one thing that trader needs to have which is to be practical. Often traders tend to let their political views get into the trading perspective, which should never happen. Often they oversimplify the fact that certain country is not in the issue (because they let their subjective perception to over-simply the actual situation). The question for each country and its financial assets when it comes to strong drop in crude price is what kind of damage will be displayed.

At what cost, since the real cost of producing crude at very low prices (even if above break-even of per-barrel cost) is the inflation. The currency suffers fall, inflation rises, financing in the energy sector dries up (from international lenders), which all tends to create the result of rising inflation and less credit-worthy-ness. And the real costs of inflation are not seen within a year, they are seen 5 years later.






The petrodollar: The power game between US+Saudis / Russia+China+Iran.




To understand the game of oil markets and its relation to the financial system, knowing the function of the petrodollar system and its history is a must. The global financial system in its core uses petrodollar recycling as the underlying foundation which solidifies dollar as a global reserve currency and US treasury bill as the core of all the financial instruments, backed by the demand the buying power of US consumer.



The basic premise of petrodollar recycling was established in the early 1970s when the cold war between US and Soviet Union started to take a toll on the deficits of US (increased additionally by the Vietnam war) where the internal planners of US economic system started to note that a shift in US financial system is needed.

If one was to out-spend the Soviet union it would be impossible to do so in a system where every dollar is backed by gold, and the debt system had a tight ceiling of how many dollars can be borrowed into the future.

The debt ceiling had to be extended by a large amount, which required the creation of artificial consistent capital inflows into the US (especially into the debt market of US treasuries), which is where the petrodollar comes into the picture. A special deal was struck between Saudis and the US to create dollar only global crude oil trade system, where Saudis were to sell oil exclusively in USD and those dollars would then be recycled by purchasing US government debt / T-bills. And as the Saudis were largest crude exporter at the time such action would push the rest of OPEC exporters to accept the same agreement.

This would allow the US to over-spend and achieve not just wider economic growth but to put the Soviet Union a few steps back in the race of over-spending (military, proxy conflicts, inflation) as one country had large inflows of capital into its internal debt, and the other did not. This means one country is financing the spending frenzy by the support of international participants (the US), and the other has to do it internally trough the rise of inflation by debasing the currency which caused the hyperinflationary crisis as the result (the SU).




In the later part of the 20th century, the petrodollar recycling was mainly supported by oil-exporting countries of OPEC however this later changed after 2008 where China and certain manufacturing goods producers took larger share cut instead of the oil producers.


As noted in the picture below, the number of T-bills recycled by China started to outpace the OPEC recycling by a vast amount in growth rate after start of 20th century:



Recycling and petrodollar participation in itself is a benefit and a major headache to countries as on one hand, it provides steady price fixed income of exports (oil/goods for dollars which are often more stable than currencies of EM countries), but on other hand, it creates major Achilles heel if the dollar strengthens quickly posing internal problems to the currency of that country and the interest rates themselves.

It overlies the whole financial system of the country itself to be prone to major issues if the dollar liquidity suddenly stops flowing into the country (due to sanctions for example) as it was present for Iran / Qatar in 2019 or is upcoming for China.

Once the country has participated in petrodollar for a while, the financial system gets addicted to inflows of dollars to finance growth activity and expanding debt, and if such flows stop it posses major problems as well as creates strong demand for dollars globally, especially to re-pay the debts. This is one of the key components to understanding when it comes to upcoming situations between the US and China as it will play a large role in terms of how petrodollar will dictate the shift of global capital and certain asset classes. It might just as well have major impact on crude oil price behavior as well into near future.



Now to not go into too many details of why tracking the petrodollar recycling is so important for crude oil trader and its cycles, it is important to note that a large amount of US deficit spending is financed through petrodollars, and the countries which willingly shift its policies to abandon such participation are at absolute cross-hair targets of US administration, such as it was the case of 2001 Iraq decision to exit the petrodollar agreement and sell crude in Euro instead, or 2012 decision of Russia, and Iran in 2009. Not necessarily are those initiating decisions as they are just likely result of previous actions, but they do certainly pose large consequences and the actions triggered after that, all of which had a major impact on crude oil price (2003 and start of the war in Iraq saw large rally cycle in crude price, 2009-12 Irans counter actions saw spikes here and there, 2014 saw large crude oil collapse as a result of contributing decisions on part of the Russian government).



One of the common misconceptions is that many macro readers believe that the US and Saudis are often in conflict when it comes to moves in regulating the supply of crude production. That is certainly not true, as both of those countries work relatively close together in cohesive maneuvers and it is rather rare that Saudi Arabia initiates the move that is not well discussed with the US first (example of where Saudis and the US went on cross-path was in the early 70s and intentional supply cut of SA).

But in general, the supply production flows of Saudis are cohesive with the US for the most part as Saudis still remain one of the key players of the petrodollar and the capital recycling for the US. It is very easy to get miss-directed if one only watches the news as certain personal opinions might mistake the actions of Saudis and Aramco often as solo decisions, while in reality it is often not the case (an example of that is 2014).



Petrodollar relationships are decent to understand for trader to lay out with better accuracy what is causing the cycle in the move of crude price, it is by no means the only component, but it has played historically a major reason and impact on crude cycles, such as:

-Saudi Arabia 1975-2008 (solidification)

-Iraq 2001-2003 (heavy bull cycle followed)

-Lybia 2011 (smaller bull cycle)

-Russia 2014 (strong bear cycle)





Personal suggestion for anyone interested, to get a better read on cycles of crude oil price it is highly recommended to study the history of the crude oil industry, especially over the last 100 years. This combined with relationships that certain crude producing countries have between each other (OPEC, US, Russia, etc...) can shine a better light, however, it is almost equally important that study material is objective and trustworthy! No subjective opinions and this is where it gets complicated, there are quite a lot of great objective publications and some not so good subjective ones as well.




Trading the shortfall



The key centerpiece upon which this article is prioritized is to initiate the trades on crude price crash as long as the move has been very strong in terms of % and there are obvious factors on global supply inventories or financial markets pointing towards drastic change in potential supply/demand stance in near term worldwide.


The move-in price has to be supported by the potential start of economic crisis or agenda supply flood which is reflected trough excessive supply glut (historically often initiated by Saudi Arabia) at the shipping of crude tankers and storage facilities and inventories.

The quicker the price drops into low territory the more pain it produces on leveraged or weaker crude producers, increasing the chain reaction in currency and equity markets.



Therefore the shortfall has to be supported by (to be traded as valid):


-change in supply capacity in inventories (ports mostly), drastic change in inventory numbers of stored crude


-change in global financial markets, signaling potential crisis in the making trough and the frequent barrage of negative news, bankruptcies and large drop in SP500 index


-change in political stance of different crude oil producers and their negotiations or supply cuts/extensions



The difference is that when the movement is slow and soft, even though if bearish overall, the energy companies can adapt by taking more debt as their credit-worthy conditions do not change much if the decline in oil price is slow, and the currencies of oil-producing countries do not drop much since the market is in the expectation that positive global growth will "bucket" the fall of crude price and eventually rebound it.


But all of that is much different when the price fall of crude is all of sudden very quick and deep and keeps progressing every day without the end in sight (under the right variables as noted above).

In such conditions the behavior of financial assets linked to crude changes as the risk of defaults increases for energy companies and countries. Those re the kind of conditions that article will touch upon to trade, both on the short but as well on long side (shorting in the middle of a crash and then longing in expectation of bottoming).

However long side of equation is more difficult in regards to trading (catch the bottom), while the short side is easier (follow the trend).



Example of a large down cycle



Below is conceptual outline of how this cycle looks on macro chart (Daily time frame):




Below is example of large down cycle in 2014 (supply shock from Saudis over-supplying the market with excessive crude):




And a cycle in 2020 (demand shock from global economy closing down):




The main focus where a trader should put attention is the middle core part of down trend. This part is where a trader can consistently trade every day along the direction of a trend across many assets on intraday trades, either by scaling in and out of positions or holding winning positions for swing for larger RR trade.




Equities - energy stocks



Two types of asset classes in equities when it comes to trading down cycle in crude:

-smaller capitalization companies (YUMA, SES, SSL, ...)

-higher capitalization companies (OXY, XOM, APA, OKE...)



Both of those asset classes provide shorting opportunities, however often the issue with smaller cap companies is that they provide less RR since liquidity on the stocks is poor, and the overnight borrow fees on shorts are expensive, all of which provide more and better intraday opportunities in larger capitalization stocks. This is especially true since statistically it is more likely that small-cap energy stocks might be in downtrend already (before cycle starts, due to its poor balance sheet and dilution) which creates less reward in a short position as stock is already beaten down, which is usually not the case for larger cap energy stocks.


There is somewhat a balance between the two and it mainly depends if the small-cap asset is relatively liquid and has still somewhat uptrend before the down cycle in crude behind it might be a worthy consideration for short. However large-cap energy stocks are much more straightforward, those are ideal to short no matter what, for the majority of cases.


Below is outlined the case for the small-cap company which is less ideal to trade, since it does not provide enough daily trading range, and majority of down move on price is made on gap moves in after hours rather than intraday moves.




My preference is to use three different approaches in such conditions for large-cap companies such as ticker OXY or XOM (Occidental Petroleum and Exxon Mobil):


1. Buying long term puts with 1-month expiration (options) to create a less time-intensive complimentary trading method which is not as intensive as shorting a stock (allows less precision on timing).


2. Shorting in the first 30 minutes of market open if the asset is weak, consolidates, and is unable to push.


3. Shorting any A-grade micro setups with much stronger size, one of my personal favorite is distribution on the backside (in middle of intraday downtrend).



Example of method 1,2 and 3 combined on energy stock (such as XOM for example) in the core down cycle of crude oil drop (intraday 1-minute chart):



Below are some intraday chart examples of ticker OXY of 2020 crude crash:






The method above requires solid risk management as well and even if the macro trend is in the clean direction down it does not mean that intraday each time the energy company stock will perform with an "ideal" scenario. For this reason, using puts with 2-4 day expiration compliments the 3 methods above well, because it offsets some of the losses that the trader takes intraday on underlying stock when the trade does not work.


The core idea is to follow the bearish trend in energy stock, using some sort of indication to define trends such as highs and lows or the use of indicator, then the second part of the equation is that crude price on that day needs to display weakness intraday, and this should then provide the trader with a bearish bias. The stronger the drop in crude the better shorting opportunity on energy stock could be especially if stock is not yet dropping in pre-market hours but the crude is.



Example of ideal and less ideal shorting opportunity:





The premise being is, the longer the energy stock lags to drop in relation to the crude price response the better it is, as this means that there is a higher chance for the market to still re-price that energy stock lower sooner or later.

While if stock is already following crude price 1:1 (full correlatetion) on the downside this creates smaller shorting opportunities, in terms of price distance (the market has already priced in the reality up to an medium or large extent).

Obviously, this is not exactly the same for every company, as there are more variables that matter to define if it is worth "chasing" on the short side dropping stock of energy company, but the rule above is the very useful and quite robust rule applicable for any stock/ticker.


The point being is that crude price is used as leading indication to really show and confirm that strong bearish cycle is in development, and the trader uses that indictaion to then build short positions into energy stock if crude is responding to downside. And since crude oil trades in futures contracts pretty much 24/5 this also allows trader to prepare before NY market open if crude is dropping during Asian or European session.


Obviously for this reason trader needs to track crude oil charts every day, with as many updates as possible, using leading crude benchmarks such as:

-WTI

-Brent

-XTI


This article outlines core of how trader can approach to trade equities in the middle of cycle, but it is a must to historically test those methods to confirm if trader would gather required performance or not, and if certain approaches need adjustment.




Forex markets (emerging)




There are many assets trough which the drop in crude price can be played, but perhaps one of the most straight forward ones are currencies. Especially currencies of crude producing countries with a higher cost of oil production, in emerging markets. Those assets will provide plenty of shorting opportunities as the price of crude keeps progressing lower.


The fall of currency will usually be the result of:


-fear flows from international investing capital as the bonds of such country usually tend to drop strong and the default chances skyrocket (even if over-reacted), which scares large capital, weakening currency of such country


-hedge swaps in currency from wealthier people inside of country who swap internal currency for dollars to hedge against inflation and economic downturn. This often has a large impact on actual exchange rates and the currency supply of dollars inside the economy, worsening the drop of internal currency (more demand for dollars, less demand for internal currency).


-banking sector facing turmoil as many indebted oil companies inside the country begin to struggle, causing capital outflows from the internal banking sector into safer sectors, usually the US


-uncertainty whether the oil industry of that particular country will face large amount of defaults, exposing the whole economy to layoffs (unemployment) and loss of revenue.


-.....


Examples of tradeable currencies with the plan outlined above (emerging + non-emerging market): CAD, RUB, MXN, NOK.

(USD is exempted from the equation, while the US is a major crude producing country, the reaction on currency is by no means the same as other crude producing countries since fear capital flows usually suck the capital into the US from external higher risk producing nations causing a "bucketing" on dollar decline, as well as US financial system as explained above can withstand much higher pressure.)


The stronger and the more surprising the drop in crude price is, the better the shorting opportunity of such FX currencies, as the less time that market had to prepare for such an event the more downside market has to price onwards for the currency of such oil-producing country. And let's face it, the majority of major crashes in crude prices are very surprising to the majority of market participants even if one is tracking the inside and top players very closely. For example even though that Rothschilds did liquidate a huge portion of their wealth carried in US equities exposed to the oil sector in early 2014, the majority of market participants did not take the action seriously enough, until the crude oil price started to crash seriously just 2 months after that. Coincidence? Think again.


Large drops of the crude price (especially if agenda initiated such as 2014 collapse initiated by Saudis and over-flooding the market) are very strong opportunities for traders as they create truly the most sustaining and strong trends in such FX currencies. Shorting the ruble in 2014 from 16,00 all the way to 80,00 rubles per dollar was a solid opportunity until the RCB was forced to place the emergency rate hike and stop the currency decline. In majority of cases those cascades of emerging market currencies end with an emergency rate hike of 3+% lift by central bank, however there was unique situation in 2020 where the global growth has shut down, which prevented from central banks to pull such a move in majority of countries.


To trade such a case it is key to understand why the crude price is crashing. To know if it is due to agenda (supply flood-2014) or due to suppressed market conditions (demand shock-2008 or 2020).

Without understanding the reason behind the move trader will be unable to build a conviction on the thesis or potentially to even step against the move too early. Such a case was easily observed in mid-2014 where many retailer traders were longing crude way too early in the cycle, without understanding what caused the crash expecting the price to quickly recover, which did not come to fruition for over a year.


Never under-estimate how low can actually crude price fall in the heavy bear cycle. Usually, the move is approximately 60% or in some cases even close to 80%, it can be too easy to rationalize that in an economy where daily use of crude is a must to use prices cannot fall too much, because the demand will eventually bucket the drop. If supply and demand side is skewed enough it actually can drop way further than majority anticipate such as it was seen trough last 50 years quite several times.


Below are chart examples of MXN, RUB and NOK currencies in the middle of 2020 crude crash:








The play on short side of emerging market currency



As mentioned above, emerging market currencies of major oil-producing nations are ideal to trade and great complimentary methods along with trading equities (or in the case of 2014 even leading method, especially on ruble).


Personally my two top picks are peso (USDMXN) and ruble (USDRUB). Both of those currency pairs are relatively liquid, have strong volatility which makes the cost of fees smaller, ideal for trading actively (relative to some other less-ideal currencies).


This approach however needs a solid timing, and the trader must not be too late! Shorting those currencies is all about being "in the middle of it" basically where the crude is still dropping, but the drop itself has not yet fully materialized, where the trader is initiating trades somewhat in the earlier or the middle part of the trend, not the late part of the trend. The reason being is that in the late part of crude oil crash the volatility will expand significantly both on crude and currencies (real panic starts to kick in) and that by default lowers RR on trades as it opens more risk on losing positions if the trader has to cut them since bounces at high volatility conditions can be severe.


Example of volatility conditions in early, middle, and later stage of crude collapse:



Now an observer might say, alright but how can you really tell if the trend is too extended and when it is no longer ideal to participate on the short side, surely that can only be obvious in hindsight?

Well there is a decent way to measure that with the use of volatility index as a gauge when bottoming might be taking place. A trend in OVX (crude oil volatility index) and its progression is a great way to gauge when to stay away from shorting the crude or the emerging market currency exposed to oil.


A simple rule which works relatively well (although the data is limited) is too short FX currency only when OVX is still in a clear uptrend on the M15 time frame and is progressing higher on the intraday chart (1 minute). Once there is a major shift in OVX to downside usually the bottoming process starts to develop and later stage of a trend in FX currencies is about to set in.




Once OVX kicks into a strong downtrend, and has major retrace down then it is more likely that bottom might be established. All this overlaps well with the overall timing on those crude crash cycles which last usually approx only 1 year before the price recovers or stabilizes somewhat.





The relationship between OVX and crude benchmark like Brent is basically the same as VXX an SPY (SP500), in terms of how volatility indexes and their trend+overall price can be used to establish when the bear trend might be near its end.


General behavior relationship between crude oil price (Brent or WTI for example) and OVX index is inverse when the crude price goes higher the OVX goes lower, however, this is not the case always as it depends on external factors, especially on how early in the actual trend the drop of crude itself is.

Rather OVX needs to be looked at as volatility cascade element inside the oil industry, the global economy itself, and the size/shift of the moves in crude oil price relative to their previous moves. It's not the trend or price itself that it only matters but rather how quickly the change of the previous trend was to determine the risk on/off conditions.


A trader should have crude oil intraday charts and tape opened every day and only short into peso or rubble if crude assets are following with further dropping.



There are two ways on how a trader can trade the crash of crude on FX asset (personal suggestions only):


-average building the short position into trend retraces (bull retraces against macro bear trend).


-building higher RR short entries with a highly leveraged approach with a combination of micro setups to time the entries well. For example the use of distributions or demand breakdowns to place the short entries.


The location of trade with each approach should be different, the first approach should be with retrace trade and mid-term bullish trend, while the second approach should be on confirmed backside and weakness.


An example is outlined bellow conceptually:




My personal preference is to use both methods as they both compliment each other well, but the main focus is on the second method on the right. One method is more time-intensive while other is less intensive and more "hands-off" approach, both of them complement each other relatively well as long as the scaling of position size is clearly in the favor of higher RR trades.



Below is an outline of how to use accumulation setups for USDMXN to trade Mexican peso short (USDMXN long). For those unfamiliar with Forex, longing USDMXN on accumulation is shorting the MXN (peso) as the dollar is used as the base weighted currency of the pair.



Or rotation example below:



Below is example of rotation for USDRUB (long):





The micro plays shown above for both MXN and RUB are my personal micros used, however, the trader can construct different entry approach using different combinations as long as micro does have a relative edge. By relative edge it is meant that the micro when it does perform, it has a low drawdown and goes into the needed direction at least in 50% cases of trades. And while that might sound easy to achieve, it is not, especially since in FX markets there is no tape to lean on some visibly exposed order flow, the majority has to be done through a combination of technicals, a solid understanding of current fundamental flows in the market (intraday crude / EM currency flows). By default there is no such thing as a 50% very low drawdown indicator that exists, which means that there is a lot that trader needs to combine with a very detail-oriented plan (and a lot of patience!) to achieve that.


All of this means that average shorting in approach will be more favored and easier to grasp approach.



Now there is as well a second way to approach it, which is by using average position sizing with small-sized positions, where a trader is basically trading the macrocycle of crude price drop by setting small increments of positions into FX emerging currency without risking more than 0.1% on any trade and then building a bulk of such orders and letting them run if the price of EM currency pair responds in the right way.

The benefit of such a method is that trader has to be much less accurate and precise with entries, however, the largest downside is that RR is that much lower. With such a method for example trader might at best extract 20R from the whole cycle (3 months), which for smaller capitalized trader might not be enough.


Below is shown a conceptual example of such method of average sizing in with small size:





Few advantages that shorting emerging market currency amidst the crude oil collapse has compared to shorting energy companies:

-no expensive overnight borrow fees

-ability to short 24 hours 5 days a week with no downtime in between

-ability to leverage upon position much more than inequities (10 times- 100 times more leverage), allowing to participate with smaller capital



There is one large advantage to trade on the short side in the middle of the crude collapse cycle for FX currencies which is the extent to which the market will forgive trader on his/her mistakes.

If there are strong conditions pushing currency lower each day a short seller will "get away with it" on many mistakes such as oversizing, not cutting losing position, being in the trade too early, as the general macro flow of asset will "bailout" the trade frequently. And such a thing should not be under-estimated how helpful it is! Obviously there is also B side equation of such behavior as trader is rewarded for bad behavior, but in some cases if trader has risk under control at least somewhat decently it is allowed.


However there is a downside to this as well, often if the trader is too confident into the thesis and the reasons why currency should drop further and all explained above suits the conditions but for some reason, there is drastic change all of sudden due to unexpected strong counter-catalyst it could push trader into significant loss, relatively quickly. Such situations do happen and should be taken seriously, which is why planning for all IF-ELSE scenarios in trading is very helpful to be prepared ahead and not getting into the situation of being caught with pants down too frequently.




Opportunity frequency




Ideally daytrader should be focused on opportunities that are as frequent as possible, as this provides the ability to form a consistency of performance around it. The least frequent the "pattern" is, less ideal it is, which is the case for the crash cycle of crude oil, which on average comes only once every 5-10 years.

However there is a bright light at the end of that tunnel, not necessarily just because the opportunity is very in-frequent that this by itself is not a great pattern to place into the playbook. Since what matters as well as the relative R the trader is able to gather from the pattern. With other words, if the pattern is rare but it is long-lasting (such as crude cycle crash which lasts 3+ months) then this can provide plenty of consistent intraday opportunities that quickly begin to stack up, especially if the trader has playbook built across many different markets (equities, currencies, gold, etc..).


Personally speaking crash cycle of 2014 and 2020 made as much R as the whole year altogether outside of those two years, my trading was focused on MXN, RUB on currency side and OXY, APA, and OKE on the equity side. Which means, that even though the opportunity is rare, the R collected is basically as high as any other non-crude cycle opportunity which presents itself every single day (parabolic plays, supply takeouts, and many other explained on the blog). It is not to under-estimate such rarer but strong opportunities.

The same applies to economic crisis, while perhaps less frequent pattern, once it happens it delivers several months of opportunities intraday on short side, and as well later on on the long side after central bank steps in.



It should be noted that the majority of retail traders do not get a macro read on the crash cycle correct, they are mostly long-biased, and they start to buy the dip way too early into the crash cycle (one can read COT or commercial brokers reports).

In fact, this does not apply just to retail traders, but as well as Wall Street. Wall Street had the highest net long position on crude just into the March of 2020 (buying the first dip) just when the actual crash is only about to start, and that first pullback had eventually failed. Why this phenomenon happens is relatively easy to explain.

Once a strong bull trend is established in crude oil for years (2018-2020), the majority simply expect that a strong retrace against the bull trend is just a pullback. Because of the majority of market participants are un-aware of actual macro conditions which suddenly start to shift and point to the fact that large drop might be around the corner, rather than just a bearish pullback.


Below is example of crude chart and the highest net long positioning from many participants:





Oil prices move in boom/bust cycles trough the history since of late 19th century the prices shift in cycles of strong prices followed by large crashes which are either a direct result of supply overload by larger producers to crush the smaller oil-producing nations or companies, or in certain cases the crash in price is the result of large demand shock across the entire world as seen in early 2020 or 2008.



In majority cases (in recent history), the oil rebounds after approximately a year at maximum, creating a buying opportunity, especially if the price is strongly suppressed (large % drop).



Trading the relief rally of crude, by longing FX assets




Once the bottom starts to develop in crude oil usually the emerging market currencies which are heavily exposed to crude price as major oil exporters will tend to follow up with relief rally as well next to the crude price. Usually it is because those currencies tend to drop substantially under such conditions, where the market tends to over-price the actual long term impact of oil price crash on the economy of such a country, which creates retrace in such currencies once the crude price stabilizes. However, this largely depends on additional conditions such as:


-is the central bank of such country able to raise interest rates, if not the relief rally might be delayed or does not come at all, especially if countries' economy has had major economic downfall such as the case being for Venezuela (2014-2020). In such cases the currency will not have any relief rally unless the crude price completely recovers full crash and then some more.


-does a country have large amounts of fresh external dollar-denominated debt and are major oil companies in large external debts, facing potential bankruptcies? If so is being the case, the international capital will shy away from such a country as that poses major revenue shortfall for such a country, posing doubts towards large investments from the international community. Such is the case currently present for Nigeria or it was the case for Russia in 2014.


-does a country have inflation under control, or was inflation very high even before the crude oil price shock? If inflation is rampant it affects how quickly and strongly can currency recover, with high inflationary numbers (for EM economy 10% inflation would fit the case of high numbers) it is much harder for currency to recover even if oil price rebounds strongly.



Those are just some examples of macro variables that trader should look to gauge which FX asset is worth to trade on the long side for bounce and which not. The case above as well stands true for developed market currencies as well such as the Canadian dollar, however, this largely depends if currency did have a major drop or not.



One such asset that could provide a long opportunity is the Mexican peso. Since the move was relatively explosive concerning the oil price, once global economy opens up from coronavirus situation, and the supply is burned out to extent (at stored inventories) it is likely to see a smaller relief rally in the Mexican peso, which can provide decent shorting opportunities on USDMXN asset.


However when trading such play it is critical to have a well-constructed trading plan on scaling in and out of core position, or what kind of micros to use to size position in. Using wider stops rather than tighter stops since timing such bounce is not easy. Additionally using crude oil assets (XTI, Brent, WTI) to better define when it is ideal to long peso is needed, basically waiting until the crude assets start to display initiation of bullish trend reversal and then joining with the Mexican peso long, and as soon as that trend starts to crack on crude, it is better to take of the long position on peso since it is very important to note that the trade itself goes against the long term macro performance of currency! Peso has been in falling mode against dollar pretty much since early 2013, and the trader needs to keep this in mind.


A macro overview of peso performance against the dollar since early 2013:




Below is outline of potential plan / playout for short trade on USDMXN in upcoming month or two (April 2020).





Meanwhile in correspondence the crude oil price has to initiate / follow-up with bullish trend else the plan breaks apart for peso to rally.




The Mexican peso is often a decent asset to trade crude oil cycles because it is relatively liquid, while the same cannot be said for many other emerging market currencies that are exposed to crude oil as major producers (Venezuela, Nigeria, Saudi Arabia, etc).


Additionally since the global economy came into standstill it is important to note that in case if the central bank of Mexico decided to cut the rates again by a whole percentage point the recovery bounce on peso would likely be canceled. Thus it is important for traders if one is attempting to short USDMXN for play as outlined above to keep track of policy meetings and potential for further cuts into interest rates.



USDNOK


Additionally to the MXN or RUB, a solid example is NOK (Norwegian krona) which is decent FX asset to trade bounce once crude oil stabilizes, as the article mentioned earlier the Norwegian economy is positioned much better ahead of other oil-producing countries in the crude price shocks due to its developed market and large capital cushion. This reflects well in the currency as the recovery of NOK has already been almost half of the move since early February which is not the case for ruble or peso.





Conclusion



Trading a strong bear cycle in crude oil is a great play to add to the playbook, providing very strong opportunity if played with a somewhat decent approach on the intraday basis of liquid instruments.

The downside is however, that it is not beginner-friendly as it takes several areas of markets to study, which might take a few months of studying if one is to build decent conviction.

As noted above with recognizing the cycle incorrectly one might begin to buy the dip too early, which can end with grief results. It requires to study macro topics which are related to crude market cycles, such as macroeconomics, politics, history, Middle East, US oil industry, economic crises, there is a lot that goes into it.

General trend trading approach (using just price action or indicator) without understanding the macro will not be very helpful since it will yield too many losses most likely, although i wouldn't mind to be proven otherwise.



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