Being long oil over the past 1.5 years has paid off handsomely. Between January 2006 and July 2007, oil prices have risen as much as 55 percent. Earlier this month, the price of crude even hit an all-time high of $78.77 a barrel and since then, it has pulled back approximately 6 percent. Although percentage wise, this correction is not large compared to prior moves, but the fact that the top occurred 37 cents higher than the July 2006 peak makes it a good chance of a double top.

Fundamentally oil prices are also being hit by rising inventories and falling demand. In the past, speculative buying by hedge funds exacerbated the rally in oil, but the recent blowups of hedge funds will force these same speculators to be less aggressive, less leveraged and more apt to reduce risk or take profits on any sign of weakness. The last time oil prices topped out was in July 2006 and back then, crude prices fell from $78.40 to $49.90 in six months. The latest pullback could easily see a similar degree of weakness, but even if it doesn’t it will be important to know how to hedge your portfolio against a further drop in oil prices. The trade to turn to is of course, the Canadian dollar.

Canadian dollar – The trade to turn to if oil crashes

If oil crashes, there will be ripple effects across many economies. In the Middle East, a lot of wealth and home valuations are tied to oil, making it even more important for those traders to look for hedging opportunities. The same is true here in North America. Canada’s booming economy has been fueled by the climb in oil which has benefited domestic corporate profitability. It has also sent the Canadian dollar to 30 year highs against the US dollar by boosting the international purchasing power of Canadians. As the world’s second largest holder of oil reserves, Canada has been one of the primary beneficiaries, which means that if oil crashes, it will also be the country and currency that suffers the most.

In contrast, the US stands to benefit greatly if oil prices slide. For months now, there has been a widespread fear that the rise in oil could exacerbate the problems already facing consumer spending. The lower the price of oil, the more stimulative it is for the US economy as the discretionary income of US consumers increase. This would come at a time when US consumers need every extra dollar that can get their hands on because mortgage payments are rising and lenders are tightening terms of credit. If oil does crash, it would at least be one less thing for consumers to worry about. Of course, this may bring up the question that since oil is priced in dollars, why wouldn’t the dollar suffer from a decreasing value of oil purchases. The answer is because a lot of central banks already hold reserves in dollars and the same is true for companies, which means they do not need to convert additional currency into dollars in order to fund new purchases.

This makes buying USD/CAD the perfect trade for taking advantage of or hedging against falling oil prices. The chart below shows the close correlation between Oil and USD/CAD (inverted in graph). When oil prices rise, USD/CAD falls and vice versa. Since the beginning of 2004, the correlation between these two products has been negative 90 percent. The reason for this strong correlation is because sliding oil prices would bring about improvements to the US economy and the prospects of stable US interest rates. On the other hand, lower oil prices would take away the primary factor that has been driving CAD strength over the past few years. The combination of falling oil prices and contagion from problems in the US could lead to serious underperformance in the Canadian economy in the months ahead.

USD/CAD – Already Turning

Technically, USD/CAD is already turning. On July 26, the currency pair broke its year long downtrend (see second chart). It is already bouncing and the possibility of further gains exists. It was only four years ago that the dollar was trading at 1.60 against the loonie and we are already showing signs that the sell off may be nearing an end. If you think that oil prices could hit $50 a barrel, USD/CAD is a good way to express that view. The market tends to forget that Canada is also a huge net exporter to the US. Therefore the recent strength of the Canadian dollar has been hurting exports and the economy in general. Another benefit of hedging a fall in oil prices through the Canadian dollar versus oil puts for example is the ability to earn interest. The US dollar is currently yielding 5.25 percent while the Canadian dollar is yielding 4.50 percent. This means that for each day a trader holds one regular lot or 100,000 units of USD/CAD on the long side, he or she would earn $2.20 in interest income. Therefore if you are looking for a way to hedge against long oil exposure, consider trading USD/CAD.

Kathy Lien is the Chief Currency Strategist at FXCM.