December 31, 2018

What Is Correlation and How to Trade It

What Is Correlation and How to Trade It

In the world of financial trading, asset correlation establishes how and when the prices of different financial instruments move in relation to each other. With regards to currencies and forex trading, correlation is the behaviour that certain currency pairs exhibit where they either move in one direction or in different directions, simultaneously:

  • A currency pair is considered to be positively correlated with another if their values move in the same direction at the same time. A good example of positively correlated currency pairs is the GBPUSD and the EURUSD. When the GBPUSD trades up, so does the EURUSD.
  • A negative correlation between currencies occurs when there are two or more currency pairs that trade in opposing directions simultaneously. A good example of this phenomenon is the USDCHF and EURUSD. When the USDCHF falls, the EURUSD often trades up, and vice versa.

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Types of Correlation

There are three recognisable forms of asset correlation: positive, negative and no correlation. If two assets’ prices move up or down in the same direction simultaneously, they show a positive correlation, which could be either strong or weak.

However, if an asset tends to move down when another rises, then the correlation is negative. The level of correlation is measured as a percentage figure, from -100% to 100%, also known as a correlation coefficient and it is established by analysing the historical performance of the assets.

For instance, if two assets have a correlation of 50%, it means that, historically, when one of the assets’ value was rising or falling, there was a corresponding rise or fall in the same direction in the value of the correlated asset, about 50% of the time.

Conversely, a -70% correlation means that analysis of historical market data shows the assets moving in opposite directions at least 70% of the time. A zero correlation means that the asset prices are completely uncorrelated. This means that the movement of the price of one asset has no noticeable effect on the price action of the other asset.

It is also essential to understand that the fact that correlations exist on average over a period of time, does not necessarily mean they exist all the time. Currency pairs or assets that may be highly correlated one year, could diverge and show a negative correlation the following year.

If you decide to try out a correlation trading strategy, you need to be aware of times when the correlation between assets is strong or weak, and when the relationship is shifting.

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Correlated Assets and Asset Classes

It is common to find correlations between the most heavily traded currency pairs and commodities in the world.

For instance, the Canadian dollar (CAD) is correlated to the price of oil since Canada is a major oil exporter, while the Japanese yen (JPY) is negatively correlated to the price of oil as it imports all of its oil. In the same way, the Australian dollar (AUD) and the New Zealand (NZD) have a high correlation to the prices of gold and oil.

Other common examples of correlated asset relationships include:

Taking note of asset correlations, monitoring them, and carefully timing investment windows are crucial to trading success on the basis of inter-market analysis.

Correlation-Based Trading Strategy

While positive and negative asset correlations have a significant effect on the market, it is vital for traders to time correlation-based trades properly. This is because there are times when the relationship breaks down – such times could be very costly if a trader fails to quickly understand what is going on.

The concept of correlation is a vital part of technical analysis for investors who are looking to diversify their portfolios. During periods of high market uncertainty, a common strategy is to re-balance a portfolio by replacing a few assets that have a positive correlation with some other assets with a negative correlation to each other.

In this case, the asset price movements cancel each other out, reducing the trader’s risk, but also lowering their returns. Once the market becomes more stable, the trader can start to close their offset positions.

An example of negatively correlated assets that are used in this type of trading strategy is a stock and a Put option on the same stock, which would gain in value as the price of the security drops.

Why Is Asset Correlation Important to Investors?

In the world of investment and finance, asset correlation is studied closely since asset allocation is aimed at combining assets that have a low or negative correlation in order to lessen portfolio volatility. Having a combination of assets with a low correlation reduces the portfolio’s volatility. This gives a trader or portfolio manager room to invest aggressively.

What it means is if a trader is ready to accept a certain amount of volatility, then they can put their money into high return/risk investments. This combination of low/negatively correlated assets in order to lower volatility to acceptable levels is known as portfolio optimisation.

Risk Management Tips for Correlation-Based Strategies

Sound risk management is essential when making investment decisions in order to lower the adverse effects if you suffer a loss. By using the modern portfolio theory, it is possible for you to reduce your overall risk within your portfolio of assets, and possibly even boost your returns overall, by investing in positively correlated assets.

This strategy will allow you to capture and mitigate for small divergences as the asset pair stays highly correlated overall. As the divergence of the asset prices continues and the correlation begins to weaken, you need to carefully examine the relationship to find out if the correlation is deteriorating. If so, you should exit the trade or take on a different trading approach in reaction to the change in the market.

The Final Word

If there is a negative correlation between assets, it means one of the assets’ price will go up, while the other will likely drop. When you trade each of these assets, you might succeed in any market condition, by avoiding the steep climbs and large dips expected with a single asset type. In the same way, positively correlated assets could enable you to profit from both assets if the price moves in the direction that you speculate.

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