I ‘d like to continue my talks about one of my favourite arguments: currencies correlations.
Just as a reminder… the correlation tells you how much two pairs (or two single currencies) are related: if they tend to move in the same direction (direct correlation), in opposite directions (inverse correlation) or if they don’t have any relation between them (no correlation).
Spread trading is a “non directional” way to trade with stocks or CFDs, etc. but it can be used in Forex as well.
In general, you take two pairs that are directly correlated and trade long the one that is relatively stronger than the other, while you trade short the weaker. In practice you buy the stronger one and sell the weaker one.
That way you try to reduce trading risks, still doing some profits.
How does it work? Since the two pairs (or currencies) tend to move in the same direction, if the one that you traded long is in gain, probably the one that you’re trading short is in loss.
But you “bet” on the fact that the one that you traded long will gain more than the loss you’re taking with the one you’re trading short as it is actually “stronger” than the other.
This is a “non directional” trading as you don’t care anymore about the trend as your gain comes from the relative gain/loss between the two pairs.
- you analyse the correlation between pairs
- you choose two pairs that are strongly correlated (not too much) Ex. EURUSD/GBPUSD
- wait for the moment when a pair becomes “stronger” than the other and you go long that one and short the other
This is the classical “non directional” approach to Forex Spread trading.
There are another couple of approaches: one that is about the same but that waits the periods when two pairs that are usually correlated, decorrelate. It trades those periods assuming that the two pairs sooner or later will came back “home” and came back to be correlated again.
Another approach is the “directional” one. The steps are exactly the same described above but you choose two inversely correlated pairs (Ex. EURUSD/USDCHF) instead of directly correlated. That may expose you to higher risks but it also usually leads to bigger profits.
As usual we developed a set of indicators and an EA using that strategy (directional and non directional). Both will be available in the coming weeks.