Market & Forex Correlation Made Simple

I’m forever complaining to my kids about the hours they waste online, but I have a confession. In idly looking for an image to put at the top of this email, I discovered a whole genre of videos on Youtube posted by teenage kids smashing up calculators.

And these kids seem really happy to have found a way to vent their hate of school-room maths.

Fear of anything involving some maths can follow us through life, so I know that when I start quoting correlation statistics and risk profiles, a lot of people reach for the hammer.

But hold off … I want to show you an incredibly simple way to get correlation-smart (and I promise it can save you money AND won’t involve any numbers!)

What is stock & forex correlation and why is it damaging your performance?

Global markets like to move in unison.

If the bottom fall out of the Wall St index, you can be sure that the FTSE, the German Dax, and Far Eastern markets will suffer too.

The reason this matters to us traders is that if you have more than one trade on at a time, or you own stocks, or have any kind of index-related investment – you could be doubling-up (or worse) on your risk.

So, what causes these markets to move together? The companies that make up big stock markets tend to be global giants, so their fortunes are intertwined. Plus, because investors know these markets move together – if one looks too pricey compared to the others, they’ll sell that.

In this way, correlations form a feedback loop.

If French car manufacturers look expensive compared to German ones, investors will sell their French stock and move the money into a German one. So, the value of the French market falls into line with the German.

And, when the value of stocks are falling, investors look for other places to store their money – hence money pours in safe havens, like gold and silver, or ‘safe’ currencies like the Japanese Yen or Swiss Franc.

Correlations between stocks and currencies can be more messy. For a lot of time, people viewed a strong US dollar as bad for stocks, while a rising stock market was associated with a falling US dollar. However, central bank policy muddies these waters, and just this week we’ve seen the value of the dollar and stock markets tumble together.

And this is about as far as many of us get … correlations are tricky to evaluate, and get put into the ‘too difficult’ file.

The result is volatile ups and downs in our results, which can wipe our trading accounts out at worst, and damage our long-term profits at best. (If you’re in any doubt about the long-term cost of volatile returns, please read this.)

Trading blind spot

A study written at the end of last year by economists Erik Eyser and Georg Weizsacker showed that we’d rather lose money than tax our brains with thoughts of market correlations.

In their experiments, they found that subjects chose portfolios that were heavily weighted towards a risky asset above ones that were balanced by hedging.

They drew two conclusions: first that people tend to ignore correlations; and second that they prefer to split investments equally rather than balance them based on risk profiles.

It’s the portfolio equivalent of always spreadbetting at £1 a point, irrespective of the risk on each position.

So, what should we do?

Correlation quick-fix

If you try to do some research into market correlations, most of us will quickly feel overwhelmed.

There are plenty of online tools offering to calculate the daily, weekly, hourly, 5 minute correlations between obscure currency pairs.

So, I find out that USDCHF has +61 correlation to USDJPY on a daily chart … what do I do with that information?

The problem with too much data on correlations is that it can be misleading. Market correlations change over time. This is great news if you’re actively looking to profit from the way markets move into and out of correlations, but if you’re just trying to get a balanced risk on your account, it’s too much information.

A better, simpler and more meaningful way to manage your correlations is to do it with a very general light touch.

Consider the possible scenarios … a market crash? An interest rate announcement? A recession? High inflation? What would these do to your investments? Will they all move the same way?

If the answer is yes, then you need to look at a rebalance.

In short, there’s no fancy maths required to have a balanced, diverse portfolio or trading account – just a little awareness of how markets react to big events.

Of course, correlation doesn’t have to JUST be about protection – it can actively make money, too

Yes, a little knowledge about correlations will mean that you’re not over-exposed, and can hedge your trades against big risk factors. But there’s another way to use correlation … by trading how correlations change, while knowing that you’re always hedged against big market sell-offs and major news events.

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