What Is Correlation? – Correlation Types, And More
Correlation In financial trading, asset correlation establishes how and when the prices of different financial instruments move relative to each other. With regards to currencies and forex trading, correlation is the behaviour that specific currency pairs exhibit when they move in one direction or different directions simultaneously:
- One currency pair is considered to be positively correlated with another if their values move in the same direction at the same time. An excellent example of positively correlated currency pairs is the GBP USD and the EUR USD. When GBPUSD is trading higher, so is EURUSD.
- A negative correlation between currencies occurs when two or more currency pairs are trading in opposite directions simultaneously. An excellent example of this phenomenon is USDCHF and EURUSD. When USDCHF falls, EURUSD often trades higher and vice versa.
There are three recognizable forms of asset correlation: positive, negative, and uncorrelated. If the prices of two assets move up or down in the same direction simultaneously. They show a positive correlation, which can be strong or weak.
It is established by analyzing the historical performance of the assets. The level of correlation is measured as a percentage figure, from -100% to 100%. Also know as the correlation coefficient. However, the correlation is negative if one support tends to go down when another goes up.
For example, suppose two assets are 50% correlate. Historically value of one of the assets rose or fell. There was a corresponding rise or fall same direction value of the correlated asset—about 50% of the time.
In contrast, a -70% correlation means that analysis of historical market data shows that assets move in opposite directions at least 70% of the time. A zero correlation means that the asset prices are not correlated. This means that the price action of one asset does not have a noticeable effect on the price action of the other asset.
It is also essential to understand that correlation exist on average over a while does not necessarily mean that they exist all the time. Currency pairs or assets that may be highly correlated one year may diverge and show a negative correlation the following year.
Suppose you decide to test a correlation in a trading strategy. In that case, you need to consider when the correlation between assets is strong or weak and when the relationship is changing.
Assets And Correlated Asset Classes
For example, the Canadian dollar (CAD) is correlated to the oil price as Canada is a significant oil exporter. In contrast, the Japanese yen (JPY) is negatively related to the cost of oil as it imports all of its oil. In the same way, the Australian dollar (AUD) and the New Zealand dollar (NZD) have a high correlation with the prices of gold ( investments in gold ) and oil.
Other Common Examples Of Correlated Asset Relationships Include:
- Airline stocks and oil prices
- Stock and gold market (often, but not always)
- Large-cap mutual funds generally positively correlated with the Standard and Poor’s ( SP500 ) 500 Index.
It is advisable to take note of asset correlations, monitor them and carefully schedule investment windows which crucial for successful trading base on cross-market analysis.
Correlation Based Trading Strategy
While positive and negative asset correlations significantly affect the market, it is vital for traders to correctly time trades based on correlations. There are times when the relationship breaks down; those moments can be very costly if a trader doesn’t quickly understand what’s going on.
The concept of correlation is a vital part of technical analysis for investors looking to diversify their portfolios. During periods of high market uncertainty, a common strategy is to rebalance a portfolio by replacing some assets. That are positive correlation with other assets that are negatively correlate with each other.
In this case. The asset price movements cancel each other out, reducing the trader’s risk and lowering their returns. Once the market becomes more stable, the trader can close their offsetting positions.
An example of negatively correlated assets used in this type of trading strategy is a stock and a put option on the same store, which would gain in value as the price of the stock falls.
Why Is Asset Correlation Important To Investors?
In investing and finance. Asset correlation is closely studied as asset allocation aims to combine assets with a low or negative correlation to decrease portfolio volatility. Having a mix of help with a low correlation reduces the portfolio’s volatility. It gives a trader or portfolio manager room to invest aggressively.
Meaning, if a trader is willing to accept a certain amount of volatility. They can invest their money in high yield/risk investments. This combination of low/negative correlate assets to reduce volatility to acceptable levels is know as portfolio optimization.
Risk Management Tips for Correlation Based Strategies
Good risk management is essential when making investment decisions to reduce the adverse effects in the event of a loss. Using modern portfolio theory makes it possible to reduce your overall risk within your asset portfolio and possibly even increase. Your overall returns by investing in positively correlated assets.
As the asset price divergence continues and the correlation begins to weaken, it is necessary to carefully examine the relationship to determine if the correlation is deteriorating. If so, you should exit the trade or take a different trading approach in reaction to the change in the market. This strategy will allow you to capture and mitigate small divergences as the asset pair remains highly correlated overall.
The last word
If there is a negative correlation between the assets. The price of one of the assets will go up, while the other will probably go down. When you trade each purchase. You can succeed in any market condition by avoiding the steep rises and significant falls expected with a single asset class. In the same way. Positively correlated assets could allow you to profit from both holdings if the price moves in the direction you speculate.