Forex Investing: How To Capture Commodity Fluctuations

By Richard Lee AAA

The prices of commodities have been, and always will be, a hot topic. Commodity investments help investors diversify their personal portfolio risk and capture additional profit through other markets. But there's a catch. Access to these opportunities is not easy for small individual investors. The problem? Each commodity contract usually has its own investment requirements, such as initial margin requirements. Furthermore, in most cases, trading futures contracts involves more risks than investing in either stocks or bonds. (These funds make investing in gold, oil or grain an easier prospect. To learn more, see Commodity Funds 101.)

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And that's not all. There are additional maintenance margin requirements that have to be upheld, along with an understanding of the end-of-day profit and loss calculations. Although usually simple, these calculations can sometimes understate or overstate a market position, creating confusion for traders. So, with the large capital requirement and other complexities of commodities trading, how can an investor capture profitable opportunities in commodities?

The answer is simple – invest through the foreign exchange market. Like other financial markets, the currency or forex market shares directional relationships or correlations with other investment assets. Sometimes the relationships are directly correlated (they move together), other times they are inversely correlated (when one asset rises, the other falls). These relationships can help a retail investor gain access to other markets or help in analyzing global market trends. Now, let's look at three commodities that share trends with major currencies in the FX market and what makes them special.

Gold and South Africa
Gold has always been a safe haven asset. It helps in times of consumer price inflation and is seen as a physical commodity that stores wealth. The yellow metal also gains popularity in times of market turmoil and confusion. When the market turns lower and fear is rampant in the market, traders and investors seek out gold for its sustained value. A majority of the world's gold originates from the South African continent. As a country, South Africa ranks among the top-five gold producers with the likes of China, Australia, the U.S. and Russia. So, it's no surprise that the South African rand maintains a relatively tight, positively-correlated relationship with gold. This is especially true when price momentum builds and a price trend is strong in gold.

South African Rand and Gold
Figure 1: Relationship between gold and South African rand
Source: MetaTrader 4

From April of 2009 to June of 2010, the relationship remained strong, as gold prices soared to record levels and the South African rand appreciated against the U.S. dollar. Rising from about $863 an ounce, gold future prices traded to as high as $1,233.25 at the beginning of summer 2010 – an almost 43% surge. The move prompted a rally in the rand, with the currency breaking technical support at 9.83 per U.S. dollar. The South African rand appreciated by 24% during the same period. Now, although the gains aren't exactly the same, the takeaway here is that a trend in one asset will define the direction in the other asset. So, if there is a bullish trend in gold, you can bet that gains in the South African rand aren't too far behind. The relationship between gold and the U.S. dollar is typically a negative correlation. (Find out more about gold and reasons to invest in 8 Reasons To Own Gold.)

Silver and Mexico
Like South Africa, Mexico remains a top global metal producer, but its precious metal of choice is silver. In 2009, Mexico was the second-largest silver-producing country. For that year, Mexican silver mines produced almost 105 million ounces of silver – or approximately 15% of the global silver market. This makes the Mexican peso a necessity when dealing with Mexican silver miners, and creates a great market opportunity for retail traders in foreign exchange or any other investment asset class. (The quest for this shiny commodity has made millionaires of paupers, and vice versa. Check out Using Technical Analysis In The Gold Markets.)

Taking a similar look at both silver and Mexican peso charts, it is clear that there is a very strong relationship. At the start of the second quarter 2009, silver prices were trading just below $12 per troy ounce. This corresponded with a U.S. dollar/Mexican peso exchange rate of just below 14 pesos per U.S. dollar. With momentum of a commodities market recovery building, silver future prices skyrocketed higher throughout the rest of 2009 (ultimately peaking at $19.45 per troy ounce in December).

During the same period, the Mexican peso gained by an impressive 10.4%. The peso's rise at that time is impressive because other major currencies appreciated by about half that amount against the greenback. A retail investor looking to diversify into silver's bull market could have vicariously captured this opportunity through the Mexican peso.

Mexican peso and silver
Figure 2: Relationship between silver and Mexican peso
Source: MetaTrader 4

Copper Prices and Chile
Copper is unlike silver or gold. Instead of being a precious metal, copper and its corresponding ore is mainly used in the production of electrical and manufacturing products. With global industries still depend on copper as a base metal, there's always going to be a consistent demand. In many manufacturing companies, copper is still used as a main conductor for certain commercial and retail products. This need for copper comes as a huge boon to Chile's economy.

Chile is a major global producer, which pumped out almost 5.5 billion metric tons of copper in 2009 – far surpassing U.S. production at just 1.2 billion metric tons. The sheer size and global output of Chile's mines has helped the country to capture approximately one-third of the overall copper market. As a result, anyone who needs copper might ultimately need to make the purchase with Chilean pesos. (Read more about copper in our commodities tutorial. Check out Commodities: Copper.)

This correlation creates a strong positive relationship between the Chilean peso and copper. Between the months of February 2010 and October 2010, the price of copper futures rose by 32% to approximately $3.80 per pound. In the same period, FX investors saw the Chilean peso return 11% over the U.S. dollar.

chilean peso and us dollar
Figure 3: Relationship between copper and Chilean peso
Source: Bloomberg

How to Position Yourself for an Extraordinary Return
Now that we've covered the major relationships in the market, it's time for the application. Let's take a look at how to take advantage of these correlations in order to reap a return.

Evaluating the daily chart below, we can see a technical buying opportunity for copper in July 2010. The commodity price is testing support at $3 per pound and is signaling a reversal as the 20-day moving average (green line) is beginning to rise above the 50-day moving average (purple line). Upward copper prices usually mean an appreciating Chilean peso.

chilean peso and us dollar
Figure 4: Fifty-day (purple line) and 20-day (green line) moving averages of copper
Source: Bloomberg

The Bottom Line
For those individual or retail investors looking to gain exposure into hot commodity trends, the foreign exchange markets provide the answer. Intermarket relationships are a great way to obtain a lower trading cost basis and increase ease of accessibility when it comes to capitalizing on market opportunities. It's just another way to use forex markets to diversify a global investment portfolio. (Opening long or short positions to cash in on a trend is one of the simplest ways to trade forex. For related reading, refer to Trade Forex With A Directional Strategy.)

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