Trading the Crude Oil Market

Introduction:

The Crude Oil Futures contract is the most heavily traded commodity in the world. Futures trading in crude oil began in 1983 on the New York Mercantile Exchange. Today, thanks to the Globex electronic trading system, crude oil contracts are traded almost 24 hours a day. The best time to trade crude oil is during the New York /London overlap when volume and volatility are at their highest.

What factors affect the dynamics of the crude oil market?

There are six major factors that effect the dynamics of the crude oil market:


1. Production. OPEC controls 40% of the world’s oil production and OPEC oil exports represent 60% of all the oil traded on international markets. OPEC’s actions and production cuts have a major impact on prices.

2. Supply. Non OPEC suppliers represent 60% of the world’s oil supply. Unlike OPEC they respond to market prices rather than manipulating them. Non OPEC suppliers produce at or near full capacity. Any production lapse or perceived threat to production results in increased oil prices.

3. Global oil inventories. Global oil reserves balance supply and demand. Excess supplies can be stored and if demand is low, the oil price decreases. Similarly, if demand is high, oil reserves can be accessed and the spot oil price increases.

4. Financial markets. Oil brokers not only sell oil, they trade contracts for its future delivery. ‘Futures’ contracts are purchased, particularly by heavy oil users, to hedge against future oil price rises that could potentially lower their future profitability. Futures contracts are sold by oil producers to lock in oil prices for a specific time-frame. Crude oil traders are speculators, their principal motive is to make money from the change in oil prices. However, they do provide the market with liquidity.

5. Demand. Most of the first world countries are part of the OECD. The demand for oil from these countries has decreased over the last decade. However demand from non-OECD countries has increased substantially over the past decade due to the fact that these developing economies are based on manufacturing which is oil dependent.

6. Spot market. Crude oil is traded globally but the price of crude oil and its value added products at a national and/or local level is influenced by global political and natural events. Even the threat of an event can lead higher price volatility especially in the futures market.

What factors affect the dynamics of the crude oil market?


1. Futures. Crude Oil Future contract trade in units of 1000 U.S. barrels. A one point move has a monetary value of $10 per contract. Futures are traded on the New York Mercantile Exchange.

2. Options. Crude Oil Options contracts are traded on the New York Mercantile Exchange. The holder of a crude oil option possesses the right but not the obligation to assume a long position (in the case of a call option) in a short position (in the case of a put option) in the underlying crude oil futures at the strike price. One option contract covers 1000 barrels.

3. EFTs. Exchange traded funds are used by investors when they want to take advantage of oil price swings. The most actively traded EFT for crude oil is the United States Oil Fund (NYSE-USO).

Define and explain volatility/ range in the crude oil market:


Volatility refers to the level of variation of crude oil prices in the market over a specified time. Range refers to the upper and lower limits of volatility of the crude oil price. A more volatile market with a greater range provides greater opportunities for the trader. The crude oil market is typically volatile during the European and US sessions.

How does volatility and range impact on the selection of appropriate GMT strategies?


When the crude oil market is showing volatility, the trend trader strategy is most appropriate. The market trades in a tighter range as the volatility decreases and at these times the cycle trading strategy is most appropriate. Volatility can be measured by using a daily chart and using an indicator such as the Stochastic Volatility Indicator.

What is the relationship between seasonality and the crude oil market?

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Seasonality is a seasonal fluctuation or cycle forming a trend or pattern. However, as shown in the above graphs, it would appear that the late 2011 – 2012 cycle (WTRG Economics graph) is inconsistent with the overall 24 year seasonal chart (www.seasonalchart.com graph). Seasonality charts need to be used with caution in this market as predicting the crude oil price based on past performance can lead to an incorrect market bias.

How do market correlations impact on the crude oil market?


Trading diversified markets means trading markets that do not correlate too closely. This is to avoid a heavy draw down and to protect profits. For example, the US T-Bond price falls if the price of crude oil rises. Therefore, these two markets have a negative correlation. However, the price of gold will also rise if crude oil prices increase so the gold market correlates closely with the crude oil market. At the time of writing, I am still researching other correlations and non-correlations for the crude oil market.

Summary:


Trading the Crude Oil Futures market provides the trader with more than enough liquidity, range and volatility to be considered a suitable candidate for trading with GMT strategies such as the trend trader and the cycle trader, depending on whether the market is consolidating or trending.

Trading Crude Oil contracts would be most advantageous during the European/US market overlap when volume and volatility is at its highest. Objectively testing the times of the day, short versus longs and days of the week would provide the trader with a sound trading plan. Having an effective money management system and a disciplined trading approach would arm the trader with a profitable market strategy.