Trader Tip: Instrument Correlations Most people that have cancer have eaten pickles – so therefore pickles causes cancer. Correct? Of course this is silly logic. This just shows that we do need to be careful with correlation in the markets. That being said, some correlations do apply. In this article we want to discuss a few instrument correlations to see if we can use this concept to give us a trading edge.
The most common instrument correlation in Forex are the currency pairs that are often tied to a Euro or Dollar basis. This is some what broad and won’t give you specific leading indicators between the Forex pairs. So we want to focus on more specific correlations that we trade at Blue Point Trading. The ones that come to mind that maybe useful in this context are:
- Equities tend to trade inverse treasury markets – a yield play.
- Commodities tend to trade inverse the Dollar – a inflation hedge play.
- Gold tends to trade inverse the treasury markets – cost of carrying play.
Drilling down even further, let’s look at the specific instrument correlation between Oil (proxy for commodities) and what has been thought of as the commodity currencies (USDCAD, AUDUSD and somewhat NZDUSD). There is a strong correlation between these instruments. Assuming the Dollar not being a factor into the price movement of these instruments, let’s take a look at a couple examples on how we can use this concept to anticipate price moves.
In this first example (click image to enlarge [Oil in blue, CAD inverted]), we see the notion of the “correlation catching up.” This is where Oil moves strongly and yet the underlying commodity currency has yet to reflect this change. It will never move tick for tick and the currency tends to lag the Oil move. If the currency was already going to move in the same direction of Oil, it will respond more quickly. If the currency never moves with the Oil, it often trades flat, and when the Oil move is over (or even reverses), the currency price moves will resume as before.
In this second example (click image to enlarge [Oil in blue]), we see the notion of the “correlation back to the mean.” This where the currency makes a move but the Oil does not follow. This can happen and may not correlate, but if the Oil fails to follow the currency, it can often slow down the move in the currency. Again, understand that the moves are never 100% correlated and provides for a mere confirmation bias.
We have not discussed much about an actual Trade Plan, I will let you do this. However, this trading idea is better suited as a trade Filter to either avoid or confirm trades within a Trade Plan that may have nothing to do with this instrument correlation concept. In the examples we have used a 4-hour chart, as lower level time series may not provide a good view of these correlations. If you have issues trying to eye-ball these correlations, click here, for charts where you can place multiple instruments on a chart. Click here, or watch below a video presentation of this Trader Tip.
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