The assets that are used in trading in the financial market have a fundamental relationship. This is best seen by traders in the Forex and other financial markets. Assets that are placed in the trading window repeat the movement of each other. With the release of news about the deterioration of the labor market in the eurozone, the EUR / USD pair will begin to decline in price, followed by GBP / USD, but to a lesser extent. Although Great Britain voted to leave the European Union, it still depends heavily on it.
Definition
Correlation is a term referring to a trend of changes between data series. Changes in one market affect the dynamics of another. Therefore, traders often use the correlation indicator of currency pairs during trading.
Kinds
Correlation of currency pairs can be moving and direct. The first gives more accurate results. In the case of direct correlation, both indicators move synchronously, and in the opposite, in opposite directions.
Consider the situation on the example of trading two currency pairs: USD / CHF and EUR / USD. A trader is trading the instrument USD / CHF. If the results of the technical analysis show that there is a direct relationship between the two indicators, then you can open positions in different directions. Knowing the relationship reduces the number of random signals. But reliable results can be achieved only when working with a large array of data. Moving or inverse correlation of currency pairs appears in time on a shifted data set. The change in the USD / CHF rate today reflects the movement of the EUR / USD pair in the future. The more detailed the information, the easier it is to build a strategy on it.
Data analysis
You can calculate the correlation of currency pairs using a special program downloaded from the Internet, or in Excel. The built-in CORREL function reflects the relationship of two data sets. To determine the direct correlation, you need to use the data taken from one time interval (for example, 2013), and for the opposite - from different ones (2013 and 2014). In the first case, the value of the indicator should be closer to "+1", and in the second - to "-1". The value of the indicator, equal to "0", indicates the absence of a relationship between the data.
The relationship is not constant as the market changes. It is harder to find the inverse correlation. For example, the price of gold is often ahead of GBP / USD. The relationship for this pair needs to be calculated for almost every trading day. Some couples move in different directions, others in one, but with a time delay, and others - completely copy each other. Track the dynamics of the movement is better once a month or quarter.
Applying correlation
Traders try to avoid positions that balance each other in one time period. For example, a trader decides to work with pairs USD / CHF and EUR / USD, which have an inverse relationship. When USD / CHF starts to fall in price, EUR / USD will rise.
It is better to refuse such combinations. Profit earned from the first portion may not cover the loss. A trading strategy should be based on a series of data with a direct relationship.
There are several currencies in the financial markets that have a direct correlation with the dollar: AUD / USD, GBP / USD, NZD / USD and EUR / USD. Tracking the relationship between currency pairs helps reduce the risk of loss and timely redirect investments in other assets.
Strategy on correlation of currency pairs
Grail in the financial market does not exist. No strategy will be profitable all the time. Even if it is based on the correlation of currency pairs. But in the short term, trading based on a direct relationship is possible. It is only necessary to find assets with a high degree of correlation (from 0.8) for the last year. The essence of pair trading is to find the points of maximum price discrepancies through the correlation indicator of currency pairs, sell a more expensive asset and buy a cheaper one.
Strategy Benefits
The main advantage of the pair trading strategy is the absence of a load on the deposit. Losses of one of the correlated pairs overlap with profit from the other. This strategy is also called hedging, since the second transaction opens as opposed to the first.
The second advantage is the lack of need for fundamental or technical analysis. It is only necessary to determine the maximum divergence of pairs and not be distracted by the chaotic movement of prices. But this is the main minus of the strategy. Correlation between currency pairs will not continue continuously. It is impossible to determine its duration.
Currency pair correlation indicator for MT4
Forex trading is usually carried out through a special platform. Most often it is MT4, less often MT5. To work on the chosen strategy, a special indicator is installed on the platform, which overlays the charts of currency pairs on top of each other.
Especially for trading pair trading, you can use the OverLayChart indicator. Using it, you can determine the correlated currency pairs from the charts. The principle of operation is as follows. In the platform window, you need to open the chart of any asset, for example EUR / USD, and attach OverLayChart to it. In the settings window, write the SubSymbol parameter the name of the correlated asset, for example GBP / USD, and select the color of the bars of the second asset. If the relationship between the parameters is reversed, then in the indicator settings window in the Mirroring parameter should be set to true, and if the line is false, then false.
After the indicator is launched, two charts will appear in one window at once instead of one. You can work with them in the same way as with a regular schedule: change color, timeframe, scale.
Scripts for trading
In addition to indicators, advisers and scripts can also be used to help traders. To work on the previously discussed strategy, you can use the Correlations script, with which it is easy to find interdependent tools. In the settings you should specify:
- StartTime - the period during which the program will look for correlated tools.
- Rank - type of relationship.
If you need to find a direct relationship between the assets, the program will calculate the Pearson coefficient. To determine the inverse relationship, the Spearman coefficient is calculated. The weaker the relationship, the closer the calculated value of the indicator to "0".
After the launch of the program, the relationship search is carried out for all the instruments indicated in the “Market Watch”. The process itself can be observed in the left corner of the screen. As soon as the correlation of the currency pairs of each other is found, they will be recorded in the terminal log. Even if his work is interrupted, the records will be saved. Upon completion of the work, the Correlations.txt file is generated, in which the results are displayed. Before running the script, you need to download quotes history of all assets that will be analyzed.
Trading algorithm
How is the strategy for correlation of currency pairs applied in practice? First of all, you need to determine the entrances to the transaction, that is, find on the chart the pairs that diverged as much as possible from each other, and calculate the number of points of this discrepancy. Next, you need to determine the average value of these deviations. According to them, the correlation of currency pairs will be calculated. For example, the average divergence of assets is 80 points. This means that the next deal will need to be opened when the divergence reaches 70-80 points.
No one can predict future market movements. The described preliminary analysis will avoid losing trades.
Trading rules are as follows. Upon reaching the calculated discrepancy, two transactions must be opened at once. A more expensive asset (the one on the chart above) needs to be sold, and a cheaper one should be bought. You need to exit the trades as soon as the charts intersect at the zero point.
This strategy can be applied on timeframes from 5 minutes to one hour. The greater the time difference, the less signals there will be, and the greater the profit of one transaction.
Insurance
This trading strategy based on correlation of currency pairs does not provide for the use of stop loss or take profit. But you can insure yourself against losses of further discrepancies with the help of pending orders. For example, a trader opened a position to buy EUR / USD after reaching 80 points of discrepancy. A preliminary analysis showed that the maximum difference between the pairs was 110 points. Therefore, you can immediately open a pending order for the sale of an asset when a difference of 100 points is reached. The same thing needs to be done for a cheaper pair. Open an order to buy an asset when a difference of 100 points is reached.
Correlation in options trading
This type of trading is very similar to Forex, but has its own characteristics.
If the correlation coefficient is close to "+1", then transactions in one direction cannot be concluded. In case of negative changes in the market, the trader will receive a double loss. If the value of the coefficient is “-1”, then you should not open deals in different directions for the same reason. Features of trading by correlations should be used for the good. That is, in order to hedge risks, conclude transactions on multidirectional positions with a positive correlation. Even if one tool brings a loss, the second guarantees a profitable exit.
Example: a trader made a deal to buy AUD / USD. The price began to decline. In this case, you need to conclude a deal on the correlated pair NZD / USD for sale. Profit from the second asset will cover the loss from the first.
Binary options based on correlation of currency pairs have their own characteristics. Unlike Forex, a pending order cannot be set on them. That is, you will have to observe the changes online and stop the deal manually.
The second feature of trading comes from the first. When you open a binary options transaction, you must immediately specify its timeframe. Therefore, you need to conduct preliminary testing of the trading strategy on a demo account or on the history of charts.
Assets for trading
On the Internet, you can find tables showing the calculated correlation values for all popular tools. Among currency pairs, a coefficient value close to “+1” is observed for AUD / USD and AUD / NZD, AUD / JPY and AUD / CHF, AUD / CAD and AUD / SGD, as well as AUD / USD and NZD / USD, GBP / USD and EUR / USD, etc. Correlated are all assets in which the same currency is located in the first or second place.
Among goods, a positive relationship is observed in energy carriers (OIL and GAS) and metals (GOLD and SILVER). For stocks, this principle applies to securities of companies in the same industry (for example, IBM and Microsoft).
Conclusion
Correlation of currency pairs occurs when the movement of assets is interconnected. It can be unidirectional, multidirectional, or parallel. The basis of any change in prices is the economic interpretation. In trading in financial markets, correlation can be used to find entry points to and exit a trade.
The essence of the strategy, which is based on correlation, is as follows: for unidirectional assets, you need to conclude transactions in different directions, and for multidirectional assets - in one. Only in this case, you can avoid double losses and make a profit.
Hedging is not necessary, but every trader should know the basic rules of trading.