Students are often surprised when I refer to a commodity chart to answer a question on where the stock market is likely to move. What they may not realize is that all markets are related, and if you understand the correlations between the different asset classes, you will have an edge over traders and investors who simply rely on charts of their stock.
The relationships make sense when you think about it. Most traders in India are aware that if you are trading the IT companies, they are highly correlated to the US dollar as most of their revenue is collected in that currency. But the correlations run much deeper than that, and they can be used to increase your odds of selecting the proper entries and exits.
When you buy stocks, it is because you believe that the company and even the economy will be improving. When there is an increase of demand for basic materials such as copper, this is added confirmation of improvement. If the expansion stalls, then there would be a decrease of demand in copper and prices would drop. This often precedes a drop in equity prices as stock investors will react later to economic data that is released.
Commodity prices tend to be more sensitive to changes in the economic environment and can often offer a leading signal for equity traders. At the very least, they may offer a corresponding signal to increase your confidence when entering or exiting a trade. Additionally, knowing the correlation of your investments can help you choose a portfolio that is truly diversified. Why would you want to own two securities that are highly correlated? It would be better to liquidate one and place more money into the investment that is best performing. You will likely earn more and also have less to manage.
So, how can you find correlation? The easiest thing to do is to visually compare stocks and commodities on charts. You can either compare two charts or use an overlay if it is available in your software. There is also a free web resource available to compare certain commodities and even equities. Unfortunately, it is US based so you can only use it on stocks and commodities that are traded in the US. However, there are a lot of Indian stocks listed on the US exchanges and at the very least, you can compare the commodities to an exchange traded fund (ETF) that tracks the Nifty. Most individual stocks will follow the price action of the Nifty. The ETF you would use to track the Nifty in the US is INDY and the website is www.traderplanet.com/library/intermarket.
When you go to that site, you will want to launch the inter-market analyzer tool. This will allow you to compare commodities and even check correlations with stocks and ETFs. The basic comparison is run over the previous six months, but you can search for a shorter or longer time as well. Remember, correlations do change with major changes in economic and political environments. You want to make sure you are finding the correlation for the environment you plan to trade so adjust the time frame as needed.
See the high correlation between high grade copper and the Nifty? Knowing this correlation may allow you to use the chart of copper to assist you in trading decisions for the Nifty and stocks in the Nifty.
Experiment and see what correlations you can find for your market and stocks. You will be surprised at how this knowledge can improve your timing and trading ability. Until next time, trade safe and trade well