This post is part of Craig Turner’s Innovative Trading Concepts series.
Every commodity futures position you’ve had in the past, currently hold, or hold in the future can be viewed as a “cross”. The most familiar “crosses” are currency pairs, like EUR/USD or GBP/JPY, but “crosses” are not just for currencies pairs. For example, when you buy crude oil, you are taking possession of a crude oil futures contract but you are giving up something in return. You are giving up USD to buy crude oil. Your long crude position is also a short USD position. So if you are long crude, you are really in a long crude/short USD cross, or “Crude Oil/USD”.
Is this important? Am I just being a smarty pants, know-it-all broker? Consider this. If you are long crude oil futures, what happens if the USD has a sharp and sudden rally? Crude oil will decline because Crude is priced in USD. This implies that if you are long crude, you also have a short position in the USD. So if the USD rallies, there is a good chance that your “Crude/USD” position is going against you.
All Investments Have Currency Risk
What is even more important is to realize how much risk you have in your portfolio due to currency risk. Let’s say you are long Crude Oil, Gold, Corn and the Euro. You might think you have a nicely diversified portfolio of commodity futures positions. However, they are all priced in the US Dollar (Crude/USD, Gold/USD, Corn/USD, EUR/USD). In one sense, you have a massive short US Dollar position. Again, it is important to remember for every long futures position you have that is priced in Dollars, your also have a short US Dollar position.
The US Dollar represents the US Economy
Why does this matter? The US Dollar represents the US Economy as a whole. The US Dollar represents systemic risk. If you truly want to diversify your portfolio to have as little exposure to systemic risk as possible, you need to hedge out the US Dollar short positions. Let’s say a European country’s banking system is about to fail, and their largest banks need to be bailed out by the European Union. To make matters worse, let’s assume the market was completely caught off guard, and the Euro plummets and sends the US Dollar much higher. The Dollar rally puts downward pressure in all commodity futures priced in dollars. If you are long Crude, Gold, Corn and the Euro, they are all declining together. The correlation between those four futures positions becomes 1.0 because they are all priced in Dollars. They act as one large losing trade against the US Dollar.
Hedging Systemic Risk by Hedging the US Dollar
How do traders hedge out the USD and protect themselves against systemic risk? The answer is simpler than you may have expected. You simply need to be short a few markets that are priced in US Dollars. Let’s say you are bearish on the US Stock Market, Live Cattle, Japanese Yen and Treasuries. Being short Live Cattle is also being long the US Dollar. When you sell Cattle, you receive Dollars in return, so a short Live Cattle position can be viewed as a USD/Live Cattle cross. That means if you are short the Emini S&P (ES), Live Cattle (LC), JPY and the 30 Yr Bond, you are in USD/ES, USD/LC, USD/JPY and USD/Bonds “crosses”. The Long US Dollar positions will help cancel out a majority of the Short US Dollar positions you have from being long Crude, Corn, Gold and the Euro.
By having a few short futures positions to go along with a few long futures positions, you greatly hedge out your US Dollar exposure. The next time a major, unforeseen economic event happens, you are much more protected against systemic risk. The short futures positions in the S&P, Bonds, Yen and Cattle help diversify the systemic risk built up in being long Crude, Gold, Corn and the Euro. Your ability to hedge out part or all of your US Dollar risk is an insurance policy against the unknown systemic risks in our financial system.
All Positions are Crosses
In summary, get used to thinking of all of your futures positions as “crosses”. By thinking of your investments this way, you will have a greater handle of the currency and systemic risk your portfolio is exposed to. With the knowledge of understanding how systemic risk can effect your commodity futures investments and trading, you will be one step ahead of the average investor and trader the next time we are in a financial crisis.