What Is Correlation Trading And Why Is It So Powerful?

We've spoke and taught about correlation trading before here on the Trader's Blog, but today I've asked Jason Fielder (a multi-time guest blogger) to give us his insight on correlation trading. The below article is an excellent read and I HIGHLY recommend taking a few notes so you don't miss anything. Jason has told me that he will be responding to all comments and questions you post below. Also, he wanted me to give you a heads up about his new Correlation Cheat Sheets...so check that out if you have some time...but read the article first!

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Correlation Trading is a style of trading that is gaining momentum between traders “In the know”. In fact, the momentum is so strong, Correlation Trading is the cover of this month's Futures Magazine!

As soon as you understand this methodology, not only you will understand WHY it's so powerful, you'll immediately want to get your hands on a few correlation strategies. Correlation trading is all about discovering a way to see what I call “cracks” in the market.

Now for the really interesting part...

Every time these “cracks” appear, they present trades that you've NEVER seen before, and by “Fundamental Law” virtually have to do what you expect them to do.

OK, enough intro and talk...let me give you some very basic correlation examples of what I'm talking about:

EXAMPLE #1:
As temperatures INCREASE, sales of ice cream INCREASE as well.

EXAMPLE #2:
As temperatures DECREASE, the volume of clothes that people wear INCREASES.

Wow, that’s some seriously shocking stuff, isn’t it?

Ok, ok…by now you probably realize that I’m joking. Clearly, there’s nothing EARTH SHATTERING about these observations. In fact, they’re about as common sense as it gets. Everyone knows that as the weather warms up, people like to eat ice cream because it’s cooling and delicious to eat in the summer heat.

Furthermore, we all know that as the weather turns colder, people tend to wear more clothes because it’s necessary to stay warm.

These relationships (i.e. increased temperatures = increased ice cream sales AND decreased temperatures = increased clothing volume) are so “common sense” and fundamental, in fact, that we likely ignore them completely.

But imagine if blatantly obvious relationships like these existed in the Forex market? And more importantly, imagine if these “common sense” and “fundamental” relationships could be used to give you an edge and actually increase your trading accuracy and profitability?

Well, believe it or not, these relationships do exist in the Forex market…

They’re called CORRELATED PAIRS, and I’m going to show you how you can capitalize on these correlated pairs (and correlation trading in general) to make more money than you’ve ever made before trading the Forex.

What Do Correlated Currency Pairs Look Like?

The first step to profiting from correlated pairs is to learn how to recognize them.

Fortunately for us, that step is actually quite easy, all you need to do is open 2 pairs on your chart, one that will take up the top half of the screen and the next that will take up the bottom half of your screen (each will stretch from the right to the left of your screen).

I suggest you chose the EUR/USD and USD/CHF.

Even at first glance, you should be able to detect a clear relationship between these two correlated currency pairs.

Can you see how they’re almost always moving in opposite directions? Can you see how when the EUR/USD goes up the USD/CHF tends to go down…and vice-versa?

If not, look again…

As you can clearly see, the charts for the EUR/USD and USD/CHF are almost perfect mirror images of one another. When the EUR/USD goes down, the USD/CHF tends to go up. And when the EUR/USD goes up, the USD/CHF tends to go down.

This relationship is known as a NEGATIVE CORRELATION because these two correlated pairs (almost) always move in opposite directions of one another.

If the concept of negative correlation is still a bit unclear, think back on the 2nd “Shocking Observation” I gave you at the start of this article. If you recall…

As temperatures DECREASE, the volume of clothing that people wear INCREASES.

So in other words, temperature and clothing volume almost always move in opposite  directions, JUST as these two pairs do

Ok, by now you should have a pretty firm grasp of NEGATIVE correlation and what it looks like, so let’s move on to the second type of correlation: POSITIVE CORRELATION.

A good example here is the EUR/USD and GBP/USD, go ahead and open up your charts now with these pairs to see what I'm talking about.

Unlike the previous example, these currency pairs are moving more or less parallel to one another.

It’s All About the FUNDAMENTALS

At this point, you’re probably wondering, why are currency pairs (like the EUR/USD and USD/CHF) correlated in the first place? What causes these positive and negative relationships to exist?

Well much like our temperature and ice cream and temperature and clothing examples from before, currency correlations come down to basic fundamentals.

Increased temperatures are correlated to increased ice cream sales and decreased temperatures are correlated to increased clothing volume for two simple but extremely powerful FUNDAMENTAL FACTORS: comfort and survival.

People eat ice cream when it gets hot because it makes them comfortable, and they wear more clothing when it gets cold for the same reason…comfort (and in some cases survival).

The point is, the factors that drive these correlations are deeply rooted in daily life. They won’t change! Not this year…not in 10 years…NOT IN 100 YEARS!

The fundamentals behind these correlations are UNIVERSAL!

The same is true for correlated currency pairs… And I have some good news...

Just like you don’t need to fully grasp the workings of an internal combustion engine to drive a car, you also don’t need to fully grasp the detailed fundamentals behind the different currency pair correlations to profit from them!

In fact, all you really need to know is:

Strong fundamentals are behind correlated currency pairs. This gives you a consistent, predictable model from which to trade.

In other words, just like we can count on increased temperatures remaining correlated with increased ice cream sales (because it’s backed by FUNDAMENTALS of daily life), you can also count on the EUR/USD and GBP/USD remaining correlated because they too are backed by…

…UNIVERSAL MARKET FUNDAMENTALS.

Predictable Volatility = Profit Potential

Now that you understand what correlation is, how to recognize it on a chart, and the fundamentals that back it, it’s now time to discuss how we use correlation to gain an edge over other traders.

When most traders look at correlated pairs, they focus the bulk of their attention on the 98% of the time that the currency pairs do what they’re supposed to do and remain correlated.

Not me…I’ve always been more interested in the 2% of the time when correlated pairs FALL OUT of correlation.

(And if by any chance you're worried 2% doesn't sound like a lot, I can let you in on a little secret... it's PLENTY often to produce continuous trading opportunities, if you know what to look for!)

Oh, by the way, I realize it may sound a bit counter-intuitive, to look for a correlation “fall out” so please hear me out…

You now know that correlations are backed by fundamentals. But not just any fundamentals…correlations in the Forex market are backed by UNIVERSALE MARKET FUNDAMENTALS.

In other words, the currency pairs we’re trading aren’t correlated because some over-optimized, made up indicator says that they’re correlated…

…they’re correlated because REAL-WORLD market forces dictate that they
MUST be correlated.

So why does all this matter and what does it have to do with gaining that “edge” that I promised?

Well, it’s simple…

If we know that certain pairs are correlated and that those correlations are backed by real-world market forces, then the 2% of the time when those pairs fall out of correlation…we know that something has gone wrong.

We don’t know what has gone wrong, necessarily, but we do know that at least one of the currency pairs isn’t acting as it should.

For example, remember the EUR/USD and USD/CHF?

These pairs have a high NEGATIVE CORRELATION, meaning they should more or less move in opposite directions to one another.

If all of the sudden these pairs fall out of correlation and begin to move parallel to one another, then we know that something is “out of whack”.

And while it doesn’t happen all that often, it’s these times when things go “out of whack” that we’re able to gain an edge.

You see, when correlated pairs fall out of correlation, it’s just a matter of time before they go back into correlation. AGAIN, these are UNIVERSAL MARKET FUNDAMENTALS that are causing these correlations, and it’s these market fundamentals that will force the pairs back into correlation.

So here’s what we know…

* We know that something has gone “wrong” because the currency pairs aren’t behaving as they should…

* We know that the pairs will eventually be forced back into correlation by real-world, fundamental market forces…

* We know that when the pairs move back into parity (i.e. correlation) that the “movement” will create significant profit opportunities…

Did you catch that last one?

*We know that when the pairs move back into parity (i.e. correlation) that the “movement” will create significant profit opportunities…

And that is where the “Uber High” probability trades come in...

At this point I've run out of room but I go into much greater detail, and even GIVE AWAY one of my top correlation trading strategies in my new Correlation Cheat Sheets.

The report won't be available forever, so I suggest you go grab it now and open your world to highly profitable Correlation Trading!

Jason Fielder