Why you should pay attention to asset correlation

When you want to spread your risk across multiple instruments, you should think about their relative correlation. Individual asset prices do not move completely independently. Knowing this dependence can greatly help traders manage risk and achieve better results.

When you want to trade (reps. invest) in the financial markets, you should think about how many instruments you actually want to, or can, trade. As a trader or investor, you have many instruments to choose from and when you decide to diversify your risk among several instruments, it is a good idea to find out their correlation with each other. The idea is not to get caught in a situation where poor diversification unnecessarily increases your exposure to an instrument and instead of diluting risk, it increases it.

What is correlation

Correlation, simply put, is a measure or indicator that expresses the relationship between two variables. In the world of finance, correlation refers to how closely two investment instruments (or asset classes) are related to each other, or the extent to which the price movements of two assets are correlated. The higher the correlation, the more similar the price movements of the two investment instruments and, conversely, the more divergent the price movements, the lower the correlation. So when you diversify your portfolio, or open positions in two instruments with high correlation, you may feel that you are limiting your risk, but in reality your risk is much higher than you think.

The correlation is measured by a coefficient that ranges from -1 to 1 or -100% to 100%. The closer the correlation is to zero, the less dependent the price movement of two assets is, i.e. if two assets have a correlation of 0, their price movement is not related at all. When the correlation is 1 (100%), it means that the price movements of the two assets are the same; when the correlation is -1 (-100%), it means that the asset prices move in exactly the opposite direction. Generally, a correlation above 70 and below -70 is considered a high correlation, when it is between -20 and 20, asset prices are virtually uncorrelated.

Investors vs. traders

For long-term investors, correlation is a very good tool to help diversify effectively. For them, both correlation between asset classes and correlation within asset classes are important. For example, commodities are generally considered to be a good diversification tool due to their low correlation with equities or bonds, but within the equity component of a portfolio an investor can target different sectors whose correlation is also relatively low.

For short-term traders who trade forex or commodities, understanding the correlation between individual pairs, or between currencies and commodities, is also very important in managing the risk of open positions. Correlation can be used by traders in hedging, for example. By opening opposite positions (short and long) on pairs that have a strong positive correlation, or the same positions (short or long) on pairs that have a strong negative correlation, they reduce the risk of potential losses. On the other hand, the more adventurous and experienced can take the opportunity to open equal positions on strongly correlated pairs (or opposite positions on negatively correlated pairs) and use momentum and strong trends to increase their return potential.

What influences correlation

Correlation in forex is specific in the fact that in one instrument the trader trades two currencies, whose development is influenced by various factors that determine the individual currencies, but also their correlation with each other. Thus, different currencies may react differently to market fundamentals such as inflation, GDP, unemployment and interest rate decisions. The geopolitical situation or market sentiment plays an important role. When markets are in a bad mood and risk averse, currencies that are considered safe havens, such as the Swiss franc or the Japanese yen, tend to do better.

For some currencies, factors affecting, for example, commodity markets can also have a relatively large impact. The negative correlation between the US dollar and gold is well known, while the Australian dollar and gold have been positively correlated for a long time (Australia is one of the largest gold producers). So when you open positions in gold (XAUUSD) and pairs with the Australian dollar, it is good to keep this in mind. Similarly, there is a strong positive correlation between oil and the Canadian dollar, for example, and the New Zealand dollar is strongly influenced by events in the agricultural and dairy markets.

The influence of various factors on individual currencies means that the correlation is not a static quantity and can change quite significantly over time. Sometimes the correlation between two assets may increase for a short period of time, but in the long term it may be low, or vice versa. However, traders can also use these changes in correlation coefficients to their advantage, where breaking the long-term correlation in selected currency pairs may represent a suitable trading opportunity (in anticipation of a return to normal).

Conclusion

Knowing the correlation between asset classes or in forex can be a very good tool for experienced traders to optimize their strategies and manage risk. Understanding correlation and its dynamics over time can help traders improve their performance and reach their targets. Trade safely!