What Is Correlation?
In the world of financial trading, market correlation establishes how and
when the prices of different financial instruments move in relation to each
other. With regards to currencies & commodities, correlation is the
behaviour that certain currency pairs exhibit where they either move in one
direction or in different directions, simultaneously. This will assist you to
diversify and keep you from overexposing yourself in a specific market
direction.
Types of Correlation
There are three recognisable forms of market correlation: positive, negative
and no correlation. If two markets’ prices move up or down in the same
direction simultaneously, they show a positive correlation, which could be
either strong or weak.
However, if a market tends to move down when another rises, then the
correlation is negative. The level of correlation is measured as a number, from
-1 to +1, and it is established by analysing the historical performance of the
markets.
Correlated markets &
asset classes
It is common to find correlations between the most heavily traded currencies
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 and oil.
Taking note of asset correlations, monitoring them, and carefully
timing investment windows are crucial to trading success on the basis of
inter-market analysis.
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 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 markets that
have a positive correlation with some other markets with a negative correlation
to each other.
In this case, the market 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.
Risk Management
Sound risk management is essential when making investment decisions in order to
lower the adverse effects if you suffer a loss.
This strategy will allow you to capture and mitigate for small divergences
as the market stays highly correlated overall. As the divergence of the market
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.
Conclusion
If there is a negative correlation between markets, it means one of the
markets’ price will go up, while the other will likely drop. When you trade
each of these assets, you might succeed in any market, by avoiding the steep
climbs and large dips expected with a single market type. In the same way,
positively correlated markets could enable you to profit from both markets if
the price moves in the direction that you speculate.
Keep in mind that this correlation heatmap was calculated using hourly
data among the different markets.
Please note the following legends that were used:
