Correlation Basics
Important Notice
Correlation trading is not a novelty strategy or a ‘black box’. Our correlation strategies are real trading strategies that have been developed and adapted to be used for forex. There is a required level of discretion and subjectivity required for profitability (if any) and efficiency. The information contained within this section is merely an introduction into the basics of correlation trading.
What is Correlation?
Correlation is a statistical measure of how two currency pairs move in relation to each other. Correlation is computed into what is known as the correlation coefficient. The correlation coefficient ranges between -1 and +1.
Perfect positive correlation (or a correlation coefficient of +1) implies that as one currency pair moves, either up or down, the other currency pair will move in lockstep, in the same direction.
Perfect negative correlation (or a correlation coefficient of -1) means that if one currency pair moves in either direction, the currency pair that is perfectly negatively correlated will move by an equal amount in the opposite direction.
What is a Correlation Trade?
A correlation trade is trading more than one currency pair at a time and viewing all the currency pairs being traded as one collective unit or trade. Only currency pairs that have a moderate or high correlation can be traded together in the direction that is determined by either positive or negative correlation. The trader must understand what currency pairs sufficiently correlate and if the correlation is positive or negative so that the direction each pair is traded can be determined. There are only a limited number of combinations that can be traded to satisfy the criteria of correlation trading and often these combinations are constantly changing due to market conditions.
Why Trade Correlating Currency Pairs?
Why Is Correlation Trading Effective?
Some of the aforementioned events are scheduled on the economic calendars published by a variety of sources, but the majority of events that have a dramatic impact on the market are not scheduled and happen at random resulting in random price action.
Fundamental Analysis vs. Technical Analysis
Traders have been conditioned into believing that there are only 2 primary ways to analyze the financial markets. There are those who believe in fundamental analysis and those who believe in technical analysis.
Fundamental Analysis: focuses on the economic, social and political forces that drive supply and demand. A fundamental analyst will look at various macroeconomic indicators such as economic growth rates, interest rates, inflation, and unemployment. All of the aforementioned is combined in order to assess current and future performance. Unfortunately, price action has not consistently followed the fundamental drivers since the near economic collapse of the financial markets in the summer of 2008. Economic releases and the deviations from expectations no longer have the same impact on a currency pair. What once had a positive impact on a currency pair may now have negative impact and it can all change again on a monthly, weekly and even a daily basis. Fundamental analysis was a reliable foundation for trading prior to 2008 but today it is dangerous and considered gambling by the trading elite.
Technical Analysis: focuses on the study of prior price movements. Historical currency data is used to forecast the direction of future prices. The premise of technical analysis is that all current market information is already reflected in the price of that currency. Technical analysis works under the assumption that history tends to repeat itself. Technical Analysis has absolutely nothing in common to the true events that cause price action. Price action does not care about support, resistance, moving averages or any other indicator when a major market moving event takes place. In addition, technical indicators by their very definition lag because they use calculations based on historical data. Any trader who uses or has used technical indicators will notice that many technical indicators also give contradicting signals and require too much subjectivity and discretion to be reliable.
Many capable traders fail when using technical indicators and begin to question their ability to trade when the reality is that the trader has done nothing wrong other than rely on a flawed trading methodology.
The majority of traders are in the middle and combine both fundamental and technical analysis. However, no indicator, economic release, economist, speculator, self-proclaimed guru, or piece of technology can predict market direction with certainty. All of the aforementioned have an equal probability of being right or wrong. It is a gamble at best. This equal probability causes a false sense of hope, reliability and dependency on indicators, tools and software.
The reason there are so many inconsistencies and irregularities that exist within the fundamental and technical approaches to trading is because PRICE ACTION IS RANDOM. It is only logical that a trader should employ a strategy specifically aimed at the random conditions of foreign exchange as this randomness dominates the market.