Using the Correlation Matrix to Trade Like an FX Dealer
Most traders, when exposed to the word “correlation”, automatically think of intermarket analysis.
- Gold is directly correlated to silver, and inversely correlated to the USD.
- AUD and NZD are directly correlated.
- EURUSD and USDCHF are inversely correlated.
- Stocks are inversely correlated to bonds.
However, when trading Foreign Exchange in particular, there are two essential ways that correlations can help you uncover market dynamics and gain the market insight of a dealer.
By using the correlation matrix, you can spot common themes within FX pairs. This will allow you to focus on the currency pairs that are in play at any given time—which will allow you to work in a smarter way.
Correlation matrix – Pepperstone Smart Trader tools.
In the example above, we have selected six sterling pairs over a 25 day lookback period. Remember, correlations tell you whether two pairs have moved in lockstep or not, and to what degree, over a certain time period. Correlations do NOT tell you whether the two pairs will continue to move in the same way.
For example, EURUSDF and USDCHF tend to move strongly opposite one another. But correlation does not imply causation. The real reasons for this behaviour are more fundamental than technical.
- The Swiss National Bank does not tolerate large swings in the value of the Franc, and thus keeps EURCHF more or less stable. Since EURCHF is “stable” and EURCHF = EURUSD * USDCHF, it follows that EURUSD must move roughly opposite to USDCHF most of the time.
- EURUSD has the US dollar as a denominator. USDCHF has the US dollar as a numerator. Given the US dollar’s importance in international trade, this “mathematical” factor alone can often give you a heads’ up on what kind of correlation (direct or inverse) to expect from two currency pairs.
The other more evident way of using the correlation matrix is to help you manage your risk more precisely.
Now, let's dig deeper into these benefits.
Setting Up Your Correlation Matrix
It is very easy to set up your correlation matrix and start using it efficiently.
- Click on the […] button to select your currency pairs.
- Select the time frame based on your trading style.
- If you are a medium to long-term trader, you might want to use the daily time frame with a 25 bar lookback period.
- If you are a swing trader, you might want to use the 4H time frame with a 100 bar lookback period.
- If you are a day trader, you might want to use the 10 minute time frame with a 100 bar lookback period.
Of course, these are only suggestions. The key is to select a time frame and a lookback period that complement your trading style, and commit to it.
- Highlight the strong correlations, in order to immediately visualise which pairs are either moving strongly in lockstep or strongly opposite one another.
Tracking Common Themes
The FX market is very fickle. There are seven major pairs and over 70 crosses! How can one person possibly keep track of everything, and identify the best pairs to trade at any given time?
Pepperstone's Smart Trader tool: Correlation matrix, focused on the British Pound.
That's where the correlation matrix can come in handy. In the example above, we have a snapshot of the correlation between GBP pairs sometime in 2016. Actually, the GBP matrix looked very similar for a few months in 2016. Can you think of the reason for this? What happened to the Pound in 2016 that was so important that it lined up all Sterling pairs for a few months in a row?
Now you should be able to appreciate the subtle usefulness of a correlation matrix; when all the crosses of a currency pair are moving in the same direction, there is usually a very good fundamental reason for this. And even without knowing what the fundamental reason is, you can still identify the overwhelming dynamic and keep that currency pair on your watch list.
GBPUSD and crosses. Even after Brexit, GBP pairs continued to move in tandem.
The correlation matrix, if properly set up, can help you track the dynamics of every regional currency. In the case of the Sterling, we used the following:
- GBPUSD (the major)
- EURGBP(the closest trading partner)
In the chart above, you can clearly see how the Pound is strengthening “across the board”. This is precisely how dealers track movers and shakers. When one currency is strong or weak across the board, and all its crosses are highly correlated, you can bet there is a very strong fundamental reason behind the move and it will be easy to ride the trend.
Furthermore, when correlations are so high, you can also spread your risk capital amongst two or three different pairs. This way, you reduce the risk of identifying the market drivers correctly, but on the wrong instrument. We will never know ahead of time which pair will be “the winning horse”, so when there is a strong correlation amongst crosses, splitting our risk allocation amongst two or three candidates makes more sense. We can then ride the winning horse and reduce risk on the slower performers.
To make matters even clearer, compare our observations on the Pound with the following Australian dollar screen:
Australian dollar vs. major trading partners – Pepperstone MT4.
As you can see from the chart above, the Australian dollar is not in the same ballpark as the Pound. The Australian dollar is weak against USD, CAD, and GBP, but it's very strong against JPY and rangebound against Euro and NZD.
But if we look at the correlation matrix, it will tell us all of this in a heartbeat.
Correlation matrix of Australian dollar – Pepperstone Smart Trader tools.
So what is the matrix telling us? That the Australian dollar is not in the driver seat. From a visual perspective, we don’t see much red. There are only four pairs exhibiting strong correlations. We see a predominance of “weak” correlations and that is not interesting from our perspective. It's being pushed around by dynamics on other currencies. Using the correlation matrix each day can help ascertain which currencies are in the driver seat, and which ones take shotgun.
- Select all six crosses for one regional currency.
- Observe the colour coding of the matrix.
- Determine if there is a lot of red or perhaps red and orange. The regional currency (GBP in our case) is most likely driven by a solid fundamental reason.
- Seek to understand the reason (driver).
Using Correlations to Allocate Risk
The other important feature of the correlation matrix is the easy allocation of risk.
Euro correlation matrix – Pepperstone Smart Trader tools.
If you have identified a theme in a certain currency—hence identifying the “driver” of any given day or week—you will then need to drop feed your risk capital onto the best looking pairs.
So what's the play? If we have three or four highly correlated pairs, should we just choose one of them that we like “because they will all move in a similar manner”? Or do we split the risk amongst two or three of the best looking pairs for the very same reason?
One way to view this issue is through the lens of your personal objectives. If, for example, the objective is to pick the “winning horse”—the currency that will demonstrate the best performance and give us the best return—it may be better to split the risk allocation amongst various correlated pairs.
It's already difficult enough to identify clear drivers and strong themes in the currency markets. If we then think we're good enough to pick the best currency each and every time, we fall into yet another mental bias that will harm us more than help us. So, instead of risking say 2% on one single currency pair, try risking 0.5% on three pairs, so that one of them might develop into the multi-day trend trade we all aspire to catch.
Over to You
The correlation matrix is a very neat tool that allows us to quickly spot strong correlations, not only amongst the major pairs, but also amongst the crosses of a given regional currency.
If you attempt to identify the situations that show high correlation amongst pairs, and then track that back to the fundamental influences that are driving the correlation, you will be in an excellent situation. You will understand why the currencies are behaving the way they behave, and you will be able to make sense of the technical behaviour on your charts.
It's like boxing with both arms (technical and fundamental), instead of just one (technical).
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