Lessons from the Pros


Inverse Correlations as an Edge

Each day the global financial markets are impacted by events that cause traders to react in dramatic fashion.  These responses, quite often, will have a ripple effect that can stretch across all types of markets and asset classes.  In other words, what happens in one market will in turn move another related market. For newer traders, it’s important to understand this relationship. In this post, I’ll go over some of the strongest inverse market correlations and their uses to help traders gain an edge.

Free Trading WorkshopHowever, before we get started there is one major caveat about this topic: correlations usually hold, but there are times when what seemed to be a strong correlation between two markets suddenly change and the edge is lost. This is often a temporary phenomenon, as strong correlations always revert back. An astute trader must be atune to these changes and be flexible enough to make the adjustments necessary to keep his edge.

The first inverse correlation we’ll go over is the one between stocks and bonds.  For stocks, we’ll use the ES (S&P 500 mini) against the (US) 30 year treasury bond futures contract to do the analysis.  This is a simple risk-on versus risk-off correlation.  What is meant by this is that theoretically, stocks are inherently riskier than bonds and therefore when stocks are moving higher investors generally have a bigger appetite for risk and would sell the lower yielding, safer bond market.  This change, however when things get rough in the stock market.  Investors seek the safe harbor of treasuries, and in order to raise the cash necessary to purchase these fixed yielding instruments they sell their stock holdings.

The charts below illustrate these inverse correlations:

Inverse correlations in the currency market.

What is an inverse correlation?

We can see that major inverse moves happened pretty regularly in these two asset classes. The key for traders is to find both markets entering opposing levels simultaneously, thus increasing the probabilities of timing the turning points.  This correlation is important for traders who engage the markets on an intermediate-term time frame as it can be a major odds enhancers. Identifying the quality supply and demand levels is the most important element of this equation.

The last inverse correlation we’ll look at is that of the US Dollar index against the Euro Currency.  This is a very strong inverse correlation because of how the Dollar Index is comprised, and the way the currency futures contracts are traded.

Learn to trade forex.

Example of inverse correlation on a forex chart.

First, the Dollar index is a basket of currencies traded against the US Dollar. The biggest component of this index is the Euro currency constituting over 57% of the index. In addition, currencies futures are only the major global currencies relative to the US dollar.  Because of this, the moves in the Euro currency greatly impact the Dollar index.  Similar to the Stock-Bond inverse correlation, we can see on the charts below that all the major moves happened on the same day.

For traders trying to gain an edge, learning how different markets impact each other is a must.  Not knowing how the US Dollar can change the trajectory of commodities such as oil, copper or gold is a big disadvantage, especially when you’re competing with large banks and institutions who wouldn’t think of putting their traders on the front lines if they didn’t understand how these markets impact one another.

If you want to have a chance to compete successfully, you need to start thinking and acting like them, and part of this, is gaining an understanding of the interrelationships between markets.  My hope is that at least this is a good starting point.

Until next time, hope everyone has a great week.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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