Friday, November 27, 2009

Trading like a Couple, Correlation in Trading.

Through the last few months I have noticed that several of my customers are interested in the use of correlation in their forex exchange trading. Correlation, which is the statistical pairing of two random variables can be used in trading as it can tell us which instruments move together, which ones move opposite to each other and what percentage of the time we can expect the correlation to be true. However, there is usually an overestimation of the power of correlation in foreign exchange trading which can many times lead to invalid conclusions and the formulation of unsound trading strategies. Through this post I will talk about correlation, specifically about how it can and how it cannot be used in automated trading. I will try to discuss the usual ways in which correlation is tried to be exploited and why such uses of correlation usually generate strategies with extremely high draw down potentials.

If you do a small google search for correlation in the forex market you will find a huge wealth of websites that describe currency pairs and their relationships with each other. Of particular informative character is this website which accurately describes the meaning of correlation and how it is usually exploited in trading. Usually correlation can be used as a mean to diversify risk and to avoid the entering of contradictory positions. As per their example, if you enter a long trade on both the EUR/USD and the USD/CHF you are likely to go out with a loss as both currencies move in opposite directions. However, if you enter a trade on the GBP/USD and the EUR/USD you will diversify risk as both currencies move in the same direction, although not in exactly the same way.

So what are the ways in which correlation is exploited in automated trading ? Many people try to use correlation as a "standard" market conditions which must be returned to upon breakup from the relationship. For example, if the USD/CHF had a -90% correlation with the EUR/USD in average for the past 5 years and on a 4 month period this correlation changed to -40% people would take opposite positions on each currency until they regain their -90% "standard" relationship. This trading approach has many problems which lead to an uncapped market exposure. For example, what would happen if the extent of "decorrelation" reached levels far beyond 40% ? What precisely makes a currency unable to "decorrelate" from another ? Clearly the case can be made that while two currency pairs can remain correlated for a long time, they can quickly lose correlation because of fundamental changes.

A perfect example would be the EUR/USD and the GBP/USD which for the past few years have had a correlation above 80%. Nonetheless, after the market crisis in 2008, these pairs lost a lot of their correlation with the EUR/USD rallying towards 1.50 while the GBP/USD stayed in a very wide range from a yearly high it was unable to break. So would it be wise to always assume pairs will return to correlation ? No. Can we say up to which extent pairs will lose correlation ? No. As a matter of fact, all the systems I have seen which use returns from deviations in correlation as a trading strategy have ultimately failed. If you remember your sound training in trading you will remember the old phrase : The market can remain irrational more than you can remain solvent.

Is correlation useful ? Sure, it can be used to diversify risk and to understand and avoid the use of contradictory positions and systems. Does it have a "higher than usual" chance of success as an automated trading system ? No. Is it guaranteed that a system based on correlations will be profitable ? No. As a matter of fact, systems that are traded based on correlations often neglect the use of a stop loss or other order closing mechanism which usually makes them very dangerous and uncapped in their market exposure.

If you would like to learn more about automated trading systems and how to evaluate them and trade them profitably please consider buying my ebook on automated trading or subscribing to my weekly newsletter to receive updates and check the live and demo accounts I am running with several expert advisors. I hope you enjoyed the article !

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