2 ways to use correlations to help trade

When traders refer to looking at a correlation between to assets, they are often referring to the correlation coefficient, which is a statistical measure of the strength of the relationship between the relative movement of 2 variables, according to Investopedia. The two are terms are often used interchangeably. The strength of the relationship ranges from -1.00 to +1.00. A reading of -1.00 means that there is a perfect negative correlation between the 2 assets. They move in the opposite direction relative to each other 100% of the time. A reading of +1.00 means that there is a perfect positive correlation between the 2 assets. They move in the same direction relative to each other 100% of the time. A reading of 0.00 means that there is no correlation between the 2 assets. For the correlation coefficient to be significant, traders should look for readings below -0.80 or above +0.80.

Why do traders use correlations?

Traders look at correlations for 2 reasons:

To compare an asset to a benchmark
To look for opportunities for diversify

Using correlation to compare an asset to a benchmark

Traders may wish to buy an asset they may not have access to. One-way traders can use a correlation coefficient is to look for a high positive or negative correlation between an asset they want to own and the asset they can own and use the former one as a proxy. For example, many foreign exchange traders don’t have access to the US Dollar Index (DXY). Therefore, traders can look for an asset with a strong correlation coefficient to the DXY, such as EUR/USD and trade that instead.

Trade EUR/USD now: Login or Open a new account!

• Open an account in the UK
• Open an account in Australia
• Open an account in Singapore

On the bottom of the DXY chart below is the correlation coefficient between DXY and EUR/USD. The current reading is -0.94 on a daily timeframe. This is considered a strong, negative correlation. Therefore, because the correlation is negative, if one wants to own DXY, that traders can just sell EUR/USD (buy US Dollars).

Source: Tradingview, Stone X

Using correlations to look for opportunities to diversify

A trader may be holding an asset which may seem risky for him or her to hold onto. Therefore, that person may wish to diversity, or hedge, against that asset. For example, a trader sees a great opportunity for own Crude Oil but may wish to diversity the asset in his or her portfolio. Crude Oil and the Norwegian Krone have a strong negative correlation. Therefore, the trader can buy both Crude Oil and USD/NOK (sell NOK) to help take away some of the risk of owning Crude oil.

Trade USD/NOK now: Login or Open a new account!

• Open an account in the UK
• Open an account in Australia
• Open an account in Singapore

On the bottom of the WTI oil chart below is the correlation between the continuous Crude Oil futures contract and USD/NOK. The current reading is -0.89 on a daily timeframe. This is considered a strong, negative reading. If one wants to diversify the crude oil holdings, he or she can just buy USD/NOK.

Source: Tradingview, Stone X

One thing that is important to note about correlations is that they fall in and out of favor. Traders should be aware of when the correlation coefficient moves above -0.80 or below +0.80, as the reading would not be considered a useful tool to help them trade.

Correlations can be useful tools for help in trading if used correctly. Traders should look for readings below -0.80 or above +0.80 for the correlation coefficient to be considered significant.

Learn more about forex trading opportunities.

From time to time, StoneX Financial Pty Ltd (“we”, “our”) website may contain links to other sites and/or resources provided by third parties. These links and/or resources are provided for your information only and we have no control over the contents of those materials, and in no way endorse their content. Any analysis, opinion, commentary or research-based material on our website is for information and educational purposes only and is not, in any circumstances, intended to be an offer, recommendation or solicitation to buy or sell. You should always seek independent advice as to your suitability to speculate in any related markets and your ability to assume the associated risks, if you are at all unsure. No representation or warranty is made, express or implied, that the materials on our website are complete or accurate. We are not under any obligation to update any such material.

As such, we (and/or our associated companies) will not be responsible or liable for any loss or damage incurred by you or any third party arising out of, or in connection with, any use of the information on our website (other than with regards to any duty or liability that we are unable to limit or exclude by law or under the applicable regulatory system) and any such liability is hereby expressly disclaimed.

City Index is a trading name of StoneX Financial Pty Ltd.

The material provided herein is general in nature and does not take into account your objectives, financial situation or needs.

While every care has been taken in preparing this material, we do not provide any representation or warranty (express or implied) with respect to its completeness or accuracy. This is not an invitation or an offer to invest nor is it a recommendation to buy or sell investments.

StoneX recommends you to seek independent financial and legal advice before making any financial investment decision. Trading CFDs and FX on margin carries a higher level of risk, and may not be suitable for all investors. The possibility exists that you could lose more than your initial investment further CFD investors do not own or have any rights to the underlying assets.

It is important you consider our Financial Services Guide and Product Disclosure Statement (PDS) available at www.cityindex.com/en-au/terms-and-policies/, before deciding to acquire or hold our products. As a part of our market risk management, we may take the opposite side of your trade. Our Target Market Determination (TMD) is also available at www.cityindex.com/en-au/terms-and-policies/.

StoneX Financial Pty Ltd, Suite 28.01, 264 George Street, Sydney, NSW 2000 (ACN 141 774 727, AFSL 345646) is the CFD issuer and our products are traded off exchange.