Indicator Toolbox – Correlation Coefficient

The original Analysis Toolbox articles discussed the various market cycles including trends and continuations. This part of the The Trader’s Indicator Series focuses on the Indicator Toolbox, as we will discuss various indicators that are found on most trading platforms. We will discuss the indicator in the context of the chosen market, and if it resonates with you, please continue to do your own analysis with it. Trading successfully is all about feeling comfortable with a methodology and using that system repeatedly even when boredom sets in. I will be discussing indicators in alphabetical order that can be found on the MotiveWave platform. (for a free 2-week trial CLICK HERE)

In the last series, called The Trader’s Pendulum, we took you through the 10 Habits, all aimed to support a successful trader. Your mission in developing these habits is to get out of the Technical Trader’s Trap and transform into an Entrepreneurial Trader so that you can start being accountable to your trading. We invited you to take action and begin your journey by completing the Trader’s Scorecard (www.fxtradersedge.com/scorecard) and to get down to business by arranging a free coaching session. In this Indicator Series, we talk about the mechanics of trading.

Correlation Coefficient

The Correlation Coefficient is a measure of the price relationship between 2 instruments. The CC is positive when the instruments prices move in the same direction, negative when they more in opposite directions. The range is -1 to +1.

INTRODUCTION

The correlation coefficient measures the degree to which 2 instruments’ movements are related. A correlation of -1.0 means perfect negative correlation, and 1.0 is perfect positive correlation. When 2 instruments’ movements mirror each other, they are positively correlated. When 2 instruments move in the opposite direction to each other, they are negatively correlated.

This statistic is useful in various ways. For example, it is used to diversify a portfolio; if all the stocks, mutual funds or ETFs have high positive correlation, the portfolio is hardly diversified. By adding a negatively correlated asset to the mix, diversification benefits are realized.

In currency trading, taking positions in 2 instruments that are highly correlated will have a positive affect if the direction is correct and a negative affect if the direction is incorrect. By having positions in 2 instruments that are not so highly correlated, the two together will moderate both gains and losses.

The calculation is as follows:

If avgV1 = average price of instrument1 for the period, avgV1Sq = average of V1*V1 for the period, avgV1V2 = average price of V1*V2 for the period, var1 = avgV1Sq – avgV1 * avgV1, covar = avgV1V2 – avgV1 * avgV2; Then: CC = covar / SquareRoot (var1 * var2).

USING THE TOOL

Currency Example 1: The EUR/USD vs. USD/CHF has high negative correlation for the most part. In the 4-hour chart below, the USD/CHF is overlayed on the EUR/USD candlestick chart, with the correlation coefficient below. Most of the time the 2 instruments are highly negatively correlated (close to -1) but one can observe that there are times where the correlation dips to -.5 and below.

One can also see this by looking at the EUR/CHF chart below. A perfect negatively correlation would show the EUR/CHF cross constant, but there are times when the EURO strengthens vis-à-vis the Swiss Franc and vice versa. When looking at currency correlations, also have a look at the cross itself.

Currency Example 2: The USD/JPY vs. AUD/JPY is positively correlated, meaning, when the USD/JPY goes down, so does the AUD/JPY. In the daily chart below, the correlation coefficient ranges between 95 and 0, briefly going into negative territory. What this means is, a trader should look at the USD/JPY when trading the JPY crosses, and a comparison of all the JPY crosses will show which are more highly correlated with the USD/JPY. The chart shows the USD/JPY candlesticks with an AUD/JPY overlay, which confirms the positive correlation.

Stock Example 3: The S&P500 vs. the Nasdaq100 are highly correlated, as depicted in the chart below, with the Nasdaq overlaid on the S&P. With the markets so highly correlated, buying both indexes would not create a diversified portfolio. This is one of the ways that the tool can be used, to see how markets trade with one another. It is a form of stress testing a portfolio.

Learn how the Correlation Coefficient can be used as a tool to see how exposed a trader’s portfolio is when talking multiple positions on different markets. Start incorporating the Correlation Coefficient into your chart set-up. Finally, use the Correlation Coefficient to diversify a portfolio.

See you next week for a “D” indicator!

If your mission is to become a trader or investor who stays out of the Technical Trader’s Trap, then take the leap to grow into an entrepreneurial trader.

I created the FX Trader’s EDGE Coaching Program modelled after the “10 Habits of Successful Traders”, which is the title of my newly published book by Wiley.

The Trader’s Pendulum: The 10 Habits of Highly Successful Traders.  Copyright (c) 2015 by Jody Samuels.  This book and ebook is available at all bookstores, online booksellers, and from the Wiley web site at www.wiley.com.