How understanding the correlation between assets will help you succeed in trading

  • 17/12/2023

Trading in financial markets requires not only instinct, but also deep knowledge.

Thus, correlation helps determine whether asset prices are moving in the same direction (positive correlation) or in opposite directions (negative correlation). Understanding asset correlation is key to developing flexible and resilient trading strategies that can adapt to ever-changing market conditions.

Correlation Basics

Correlation in trading is a measure that shows how two or more assets move relative to each other in the market. This concept is key to analyzing market trends and effectively managing an investment portfolio.

A positive correlation means that assets are moving in the same direction. For example, the prices of gold and silver often rise and fall together, meaning there is a positive correlation between them.

Negative correlation, on the other hand, means that when one asset rises in value, another falls. An example is the relationship between oil prices and certain airlines. Typically, when oil prices rise, airline stock prices decline due to increased fuel costs.

Tools for Measuring Correlation

Pearson correlation coefficient

Various tools are used to measure correlation. One of the most popular is the Pearson correlation coefficient, which can range from -1 to +1. A value of +1 indicates a perfect positive correlation, -1 a perfect negative correlation, and 0 means no correlation.

Rolling correlation

Rolling correlation is another tool that helps you understand how the relationship between the prices of two assets changes over time. Imagine you have a chart that shows the prices of two assets each day, such as stocks and gold. Rolling correlation will show you how closely these two assets are related over different time periods. This connection can strengthen or weaken. For example, during periods of economic uncertainty, gold and stock prices may move more consistently, which will be reflected in an increase in the moving correlation value.

Understanding Market Trends

Understanding how macroeconomic changes affect different assets is a key aspect of successful trading. Macroeconomic events, such as changes in central bank policies, economic reports or political decisions, can significantly affect various asset classes, including stocks, bonds, currencies and commodities.

Impact of central bank decisions

Example: When the US Federal Reserve (Fed) raises interest rates, it usually causes the US dollar to strengthen. Rising rates make dollar investments more attractive as returns on dollar assets increase. It could also put pressure on emerging markets as dollar debt becomes more costly to service.

Economic reports

Example: Data on unemployment or a country’s GDP can affect the foreign exchange market and stock indices. If the unemployment report in the US shows a decline, then this will most likely lead to an increase in the dollar exchange rate, because the market perceives this as a sign of a strong economy.

Political decisions and events

Example: Elections, trade wars or geopolitical crises can cause significant fluctuations in markets. Thus, the announcement of the start of trade negotiations between the United States and China could lead to an increase in global stock markets and a strengthening of the yuan.

Strategies for using correlation in trading

Understanding the correlation between different assets can significantly improve trading efficiency and risk management. Here are some key strategies on how you can use your knowledge of correlation in trading.

Portfolio diversification using correlation

The basic idea of diversification is to include assets with different correlations in a portfolio. For example, a combination of stocks and bonds is often used to reduce overall risk, since stocks and bonds typically have low or negative correlation. This means that when stocks fall, bonds can remain stable or even rise, reducing losses in the portfolio.

Using correlation to make trading decisions

If two assets have a high positive correlation and one of them shows a certain trend, there is a chance that the other asset will follow the same trend. For example, if the price of oil rises, you can expect the prices of oil company shares to increase.

In case of negative correlation, the trader can use hedging. For example, if the stock market is expected to fall, then it is worth investing in assets that usually rise in such a situation, namely certain types of bonds or gold.

Creating a balanced portfolio taking into account asset correlation

A balanced portfolio includes assets whose correlation changes over time. This helps minimize risks and improve potential returns. For example, a mix of growth stocks and stable, dividend-paying stocks will provide a good balance between growth and safety.