The world’s economy is a giant machine that consists of many different participants. Some of these participants are allies of one another while others are enemies. For instance, the oil industry and renewable energy industry are competitors. Growth of one sector might indicate the weakening of another.
Correlations definition
Correlation refers to the relationship between two or more assets. Correlation can be positive or negative. When asset prices mimic each other’s movements, they are positively correlated. When one asset grows in price and the other diminishes at the same pace, they are negatively correlated.
Why is understanding the correlation phenomenon important for traders?
- Learning about correlated currencies or asset types can improve your analytical skills and result in better trading outcomes.
- Understanding how correlation works can save you from making uninformed decisions. For example, you might think that you are diversifying your risks while at the same time unknowingly purchasing highly correlated assets.
- Trading negatively correlated assets can help hedge your risks.
Thorough correlations explanation
In the world of finances correlations are easy to spot thanks to the modern machines that record every tick in price. Comparing one asset price with another can give us an idea on how correlated they are. Many stocks are highly correlated with their indexes. As a result, most traders use indices not only for trading but for technical analysis purposes as well.
Correlation coefficient ranges from -1 to +1 or from -100% to +100%. When assets are closer to zero, it means they are not correlated. Proximity to -1 or -100% shows negative correlation and proximity to +1 or +100 means that the assets are highly correlated.
Example of correlations in Forex
AUD/USD and NZD/USD are positively correlated. This monthly correlation matrix below implies that when the AUD/USD rallies, the NZD/USD pair also increases in value 96% of the time.
In Forex, there can be found many negatively correlated currencies as well. The negatively correlated assets can be used to hedge risks. Good example is the relationship between the NZD/USD and USD/JPY currency pairs. 84% times when the NZD/USD rallied past month, USD/JPY was losing its value.
The numbers are dynamic and a subject to change with each trading session but the phenomenon remains the same. It’s important to learn about correlations to avoid purchasing negatively correlated assets by mistake or diversifying risks into highly correlated assets.
FAQs on correlations in trading
How can I analyze correlations?
Many currency prices and industries are positively and negatively correlated. You can check out the dedicated charts. In order to analyze correlated pairs, you can learn about the technical and fundamental factors that trigger their valuation and come up with trading strategies.
What are strong correlations?
Some correlation measures use percentage points from -100% to +100% to show positive and negative correlations. Others use measurements from -1 to +1. The assets that are closest to the extremes are strongly correlated. For example NZD/USD and AUD/USD show high positive correlation based on most estimates.