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June 15, 2020

The Importance Of Market Correlations

Frank Cabibi

We now live in a world where everything is connected. Communication, businesses and even markets rely and react to each other on a daily basis, and little to none behave on their own. Global markets are probably the most intertwined entities in the world. You can watch as multiple pairs move with each other on good or bad news.

How to Spot Correlation

There is a tool that traders can use called the correlation coefficient which measures how correlated the behavior of a pair is to another source. For example, if you wanted to know the correlation between GBP/USD and Bitcoin, you can set the filter to compare them.

AUD/USD in correlation to GBP/USD

The chart above is showing the differences in correlation between the pairs AUD/USD and GBP/USD. The correlation coefficient underneath the price shows a chart from -1 to +1. -1 would be a perfect negative correlation, meaning that whenever the price of one pair goes up, the price of the other is going down. A +1 correlation means that the prices of both pairs behave the same way. A value of 0 means that there is no correlation between the two pairs. On this chart above, GU and AU are strongly correlated. A perfect correlation is not common, in fact it almost never happens. But here, you can come to the conclusion that for the most part, the two pairs will move in the same direction. There were a few short lengths of time where the correlation was not there and one time in December of 2019 where the correlation was a strong negative. Within this month, GU and AU have a nearly-perfect correlation. This doesn't mean the charts will look the same, but when AU moves in one direction, GU follows and vice versa.

Why Are Correlations Important?

Usually in times of market crashes, stocks and currencies move in unison. It's the same case during the recovery phase as well. According to Investopedia, the S&P 500 and crude oil were at a 97% positive correlation in January 2016. In times of great volatility, most stocks/currencies will move in positive correlations. This is important to note because once you've realized correlation between lots of different companies regardless of what sector they're in, you can adjust your bets and try to diversify. You probably don't want every stock/currency you own to move together in the same direction. You want diversification and options. If one trade is affected, you don't want the trades your investing in to also be affected in the same way. That's why some investors move their money trading between the US stock market and precious metals. There are strong positive and negative correlations between the two. In all, low correlation means less risk, and risk management is essential to trading.

Featured Photo: https://www.quora.com/Is-the-Crypto-Price-correlation-the-result-of-FOMO-or-market-manipulation


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Disclaimer:

Please note that this email is my personal opinion only. I am not a licensed financial advisor, and any information shared or discussed is not to be construed as investment advice. Trading and investing involves a degree of risk, and is not suitable to all investors. Please consult with your financial advisor before making any sort of investment decisions.

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