Correlation 101 6


Salve a tutti,

I wrote about correlation many times already and we just released a couple of indicators giving you real time data about the correlation score between currencies and currency pairs.

But I understand that it’s not always easy to decide what to do by simply looking at “numbers”.

So I decided to write a specific post describing some of the most important ways to use the info related to correlation scores.

First of all, let’s briefly see what correlation is.

Correlation is a measure of similarity of two data series over a certain period of time. In our case the “data series” are the “power score” of each single pair (for PotenzaFX Correlation Matrix) and the RSI value of currency pairs (for DuettoFX Correlation Matrix).

The period of time is usually between 20 and 30 bars for PotenzaFX Correlation Matrix and by default 120 bars (on 1H timeframe) for the DuettoFX Correlation Matrix.

As usual almost everything in the indicators settings is customizable.

Correlation score can go from -100% to +100%. So it has a range of 200 points.

The higher the correlation score (up to 100%) the more DIRECTLY correlated the two series are. Meaning that they tend to move in the SAME direction.

The lower the correlation score (down to -100%) the more INVERSELY correlated the two series are. Meaning that they tend to move in OPPOSITE directions.

A correlation score around 0 means that the two data series are NOT correlated and so they tend to move INDEPENDENTLY from each other.

When we look at the single currencies correlations table (PotenzaFX Correlation Matrix indicator) we are looking at the wide picture. This is what I call the currency war.

It shows you how the 8 major currencies relate to each other. During my last few years of trading I noticed that we can divide the 8 currencies into 3 general groups: the “positive” currencies, the “negative” currencies and the “neutral” currencies. There’s no judgement involved with the terms “positive/negative/neutral”, I just use them in order to fix some concepts and be able to convey them. Currencies part of the same group are directly correlated, so most of the times they move together.

  • The “positive” group is made of: AUD, EUR and NZD. I named it “positive” as when its currencies are strong/bullish also the global stock market is strong/bullish.
  • The “negative” group is made of: JPY, USD and GBP. I named it “negative” as when its currencies are strong, the global stock market is weak/bearish.
  • The “neutral” group is made of: CAD and CHF. They are neutral as they are more related to Gold/Silver (CHF) and Oil (CAD) prices. Depending on the economical period those commodities behave in different ways. Somethimes they are directly correlated to the stock market (so to the “positive” group) or inversely correlated to it (so directly correlated to “negative” group) or not correlated at all (most of the times).

In brief, “positive” and “negative” currencies tend to move in opposite directions. The “neutral” is usually not related to any.

This is a general rule and it is referred to mid/long term trading (from 4H up).

Months ago we reported – based on correlation analysis – that the GBP was moving from the “positive” group to the “negative” one. And we were right. Actually GBP is firmly part of the “negative” group now and in general it is no longer related to EUR but more to USD and JPY. This is a huge change that’s untold everywhere. So pay attention when trading GBPUSD and EURUSD thinking that they will move in the same direction. It maybe not that “mathematic”.

Why knowing that is so important?

Because when you decide to trade long or short a currency pair (for example EURUSD) you are “bidding” on the fact that EUR or USD is stronger that the other. Every currency pair rappresents a ratio between two currencies. Knowing EUR and USD correlation won’t tell you which one is stronger/weaker but will tell you that due to the usual INVERSE correlation between them, when a trend develops, it has good chances to be a “good” one. When the correlation is weak (around 0) there’s a balance between them and we’ll most likely have a ranging market. So based on that info (potentially ranging or potentially trending) we know (based on our trading strategy) if it’s the case or not to trade that pair.

Trending or ranging is neither bad or good. It all depends on the strategy that you want to use. There are strategies that perform best in ranging markets and other that perform well in trending market. We still have to find one that performs well always… 😀

So single currency correlation helps you having a broad view of the market (how the “groups” are made) and find out pairs that can develop strong trends (inversely correlated currencies), which are the best pairs for being traded with the PotenzaFX indicators or the PotenzaFX DLS Trader EA.

Most of the strategies work well in a trending market. In this case you shold look for pairs with an inverse correlation, so “red” scored. When you see a red number open the chart as you have a potential candidate for your trading.

Currency Pair Correlation Table (DuettoFX Correlation Matrix) gives you a more in depth information zooming your view.

We developed the indicator mainly for two reasons: to give you an easy tool to spot good “duettos” to be traded with the DuettoFX strategy (or EAs) and to give you a the chance to have an inter-market relation view.

DuettoFX strategy is based on finding two pairs that are inversely correlated and trade the relation between them by going long one and short the other. By looking at the DuettoFX Correlation Matrix we can easily spot the pairs that are inversely correlated (red numbers between brakes). The lower the score, the more inversely correlated, the better for DuettoFX.

When you see one, open a chart, apply the DuettoFX indicator adjusting the Instrument_1 and Instrument_2 accordingly and wait for an entry signal. You can apply the DuettoFX EAs to the newly found “duetto”. It’s up to you. But always keep an eye to the table. If the inverse correlation is no longer “strong” (below -80) you’d better not trade it anymore.

The second use is as an important inter-market relation view. Some brokers offer you the chance to trade almost everthing with CFDs/ETFs from the MT4 directly. It means that you can also trade gold/silver/oil/stock indexes/stocks, etc. We can use those info to see how all those markets are related. Are Gold and Silver moving in the same direction? Are they moving with or against the stock market? Is AAPL related to GOOG? Each of the above info can be a trade opportunity for the Forex market and not. Again, this info won’t tell you in which direction to trade (but we developed other tools for that) but it will tell you IF and WHAT to trade.

There’s a third use… pure “pair trading”. Pair trading is like the DuettoFX strategy but using DIRECTLY correlated pairs. Less profit but also much lower risks. In this case you should look for pairs that have a direct correlation (positive so green) but with scores that are not too high… let’s say between +60 an +80. Other than that you always wait for a cross and go long the stronger and short the weaker. But as they tend to move in the same direction most of the time you are trading the strength/weakness potential between them. It is a very nice safe approach to trading an you can use the same DuettoFX strategy but with a less risky approach. As said above, always check that the correlation score is in the range (+60/+80) before starting to trade it.

That’s all… quite a long post but I hope you had the patience to read it all as I’m sure that it can be very helpful for your trading success.

Have a great weekend.

A presto,
Andrea


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6 thoughts on “Correlation 101

  • Todd

    Hi
    Have you considered putting in corrilation level to enter trade on duetto ea’s?
    Also you keep giving hint’s of things to come. What is it that you keep teasing us with?
    Also have you considered putting in functions in Potenza EA similar to Duetto Swing trader?
    Such as veriable stop loss and take proffit. That with correlation might make for some good proffits? Love your work.
    Pip On
    Todd

    • Andrea Post author

      Hi Todd,

      yes we are considering that. But we are not sure if we want to put it or not. That is because we want to keep the “pair choosing” part on the human side and not only rely on algos. We released the Matrix indicators to help you choosing the right “duettos” in a very easy way. So maybe we’ll add, or maybe not :) It’s not difficult technically, but when we decide to add/remove a feature from an EA it is made keeping “safety” in mind. We want to avoid people putting the EAs to any couple of pair, simply relying on the “correlation” filter. Anyway… thanks for suggesting. And if we’ll see that it can be a really helpful addition, we’ll do for sure.

      Same applied to PotenzaFX EA. I’m working on a fixed TP/SL approach. Or a different one from the DLS. I wrote a post about a possible strategy that on visual backtests seems to work well. The strategy is the one I described here: http://pimpmyea.com/how-to-optimize-profits-and-anticipate-entries/

      Let’s see what I came up with 😉

      About things to came… I always work on developing something new. It’s a long process. Usually it takes months from the idea to the release. When one of those strategies starts to give good results I can’t hold myself and I have to talk about it 😀 But can’t say too much as I need to wait a little more. But probably next week I’ll start publishing a few equities and performance data. If everything goes as expected (bugs, etc) we should be able to release a new EA next weeks with a new strategy. I’m very excited but can’t say more :)

      Thanks to you and all the other PimpMyEA.com followers for supporting us.

      Andrea

  • Ed

    Andrea,I read all your great ideas using your indicators or EA’s but I must admit I get a little confused as to how or what indicator or EA to purchase from you.Is it possible to put a video together on how you apply each indicator or EA to your trading so I can have a better understanding on how to use your tools.Thanks and keep doing what you do.Eddie

    • Andrea Post author

      Hi Eddie,

      well the idea of the video is good. I should do one for each indicator/EA. But recording a video takes a lot of time to me :) While writing is much easier. But I’ll try to record something. Not a video with everything as it’d be a real mess, but one for each indicator or indicator set, explaining how they work and how to use them.

      Thanks for the idea.

      In the meanwhile, DuettoFX is probably the easiest strategy for now. You can read everything we wrote about it here: http://pimpmyea.com/trading-with-duettofx-explained/

      PotenzaFX is a little more complex but is the one that is more versatile as it can be used stand alone or to help you improve your trading even with other strategies. And you can read everything about it here: http://pimpmyea.com/trading-with-potenzafx-explained/

      Don’t start with EAs but with indicators. Keep them on your charts for a while as this is the only real way to understand what they “tell you”. If you still don’t get them write me and I’ll try to explain them in more details.

      Thanks for your interest!

  • Russ

    Andrea

    Thanks for all the information. I do have a request. Can you use a lighter background on MT4 for your screen shots. The black is hard to read and does not print well at all.

    Thanks

    • Andrea Post author

      Ciao Russ,

      you’re right. But usually I take screenshots from my personal platforms and I use black as background by default. Also usually if you click them you have the zoomed version so you can read them in details.

      But I’ll try to use a white background when it’s possible. Indicators like the Correlation Matrix ones don’t work well with white background.
      But I promise that I’ll do my best.