The Gold price and AUD/USD exchange rates have a historic positive correlation. This is a solid relationship amplified because Australia is the world’s second largest gold producer after China and the reason why the Australian Dollar is known as a “commodity currency.” This type of correlations exists between different asset classes because the markets are interconnected. This is not an absolute correlation, but overall when gold prices move higher the AUD/USD exchange rates will move higher (see Figure 1) and vice versa – they tend to move to the downside together too. In the figure below we can visualize the correlation and see that there is a strong relationship.
Australia produced about 10% of the world’s gold in 2015 (see Figure 2) and as mentioned above, there has been a historical relationship between Australia’s currency and the spot price of Gold. Gold and the Australian Dollar have historically been correlated assets, but the correlation has weakened recently, currently being down at 40%.
Gold and Aussie Strategy – Pair Trading
When we have such a tight correlation between Gold and the Aussie that’s the sort of the basis to establish a Pair Trading Strategy. Usually, Pair Trading Strategy is most used in trading the stock market, but the same principles can be applied to any other instruments. Simply put, Pair Trading refers to simultaneously buying a stock (or any other instrument) and selling a related stock (or any other instrument).
When volatility is low, it becomes more difficult to place trades that provide profit potential without being purely directional. A strategy to reduce some of a trader’s directional risk is pairs trading. Pairs trading extends duration, reduces risk and what is very important, it doesn’t necessarily mean higher probability profit. If the relationship breaks down, then there may be an opportunity for some trades.
As we have learned Gold and AUD/USD are highly correlated, but if the correlation breaks down, let’s say Gold rallies, but Aussie doesn’t follow Gold and moves down, then by using the Pair Trading Strategy you can exploit this divergence by shorting Gold (the strongest instrument) and at the same time going long AUD/USD (the weakest instrument). Once both Gold and Aussie reverts to the statistical mean, a profit can be made out of these trades.
For a better understanding of this medium-term strategy, it’s best to go through a real example. Let’s take the most recent price action and after a clear examination (see Figure 3) we can notice that since the middle of April and the beginning of May there has been a divergence in the correlation between Gold and AUD/USD price. While the Aussie topped on April 14, Gold only topped on May 2nd. While in hindsight it is much easier to detect the divergences, in real time it could have been spotted the moment Gold made a new high on May 2nd and AUD/USD failed to follow Gold. That’s your trigger signal for your pair trades.
You go short on Gold which is the over-performing instrument and at the same time you go long on AUD/USD the under-performing instrument. Gold sinks more than -7.20% or -$94, while the Aussie dropped -5.60% or -430 pips and the end result of the trades would be that you would have made money on Gold and lost money on your long AUD/USD. The short Gold trade however, is producing a bigger winner which is more than enough to absorb your AUD/USD loss and on top of that, you still have a nice profit.
Whenever we’re looking at pairs trades, we’re looking at the moment in time when pairs are not moving perfectly together, but when they are diverging. It is here where we tend to look for opportunities with the underlying premise being that the pairs have historically moved together and that at some future point in time they’re going to maybe move back in line. Pairs trading is a popular strategy during periods of low volatility. Pairs constructed after price extremes can lower some of the directional risks in a trade.