As an equity trader, you should be familiar with the futures markets. The futures contracts can assist you in increasing your chances for trading success in trading stocks. For instance, if you are trading oil or gas related stocks, knowing when the crude oil futures contract is hitting supply or demand will let you know how your company’s stock is likely to act.
While teaching a futures course last week, I was showing the students how to identify the relationships between related securities. If two securities are related and share a high correlation in price movement, then there may be an additional odds enhancer we can gain from their relationship.
First, correlation measures how often the two prices move in the same direction and the opposite direction. If two securities are positively correlated, their prices will move together most of the time, (i.e. they will both move up together or down together). Negatively correlated securities should move opposite of each other most of the time.
It would be rare to see securities move together all of the time. Market forces such as supply and demand will influence them differently even if they are related. But the relationships should hold over long timeframes and if they do breakdown, then that may be taken as a signal for something happening in the trend.
Let’s look at the futures contracts for the equity market indexes: the ES (S&P 500), the NQ (Nasdaq 100), and the YM (DJIA). As they are all equity index futures, you would expect them to move together most of the time and be highly positively correlated. If the correlation breaks down due to the indexes and futures diverging in price movement, that may be a warning sign of a trend change coming.
Looking at the following chart of the ES and the NQ, you can see they do move together most of the time and are positively correlated. However, when one index diverges, it causes the correlation to break down. If the correlation drops below a certain percentage, that may be taken as a warning of impending trend change for the securities.
The breakdown in correlation does not have to happen from the indexes moving in opposite directions. One security can simply stall in the trend and move sideways. It also does not give you the exact timing. The correlation breakdown is simply a warning sign for the trader.
The relationship between the ES and the YM is even stronger. Looking at the correlation in the following chart helped to signal many changes in trend over the years.
You may have noticed that I have been using weekly charts for the correlation studies. The smaller timeframes can also be used to signal intraday or short-term swing trend weakness but the accuracy of this method of analysis seems to work better on the longer time frames.
Correlation is not a perfect trading signal maker, but is can be used to increase your odds for identifying potential trend changes. To learn more odds enhancers visit your local Online Trading Academy educational center today!