In this article, we want to point out an aspect that almost always goes unnoticed by newcomers to trading: Correlation!
Procedure of beginners
Many beginners look for good trading spots and often pay attention to their very good rules of the applicable strategy. They stick to money management, the exact entry rules and all things that belong to every single trade. This is commendable, but you quickly lose sight of the big picture. Two perfectly executed trades can lead to a problem: correlation.
What is correlation?
Correlation is a term that explains the synchronization of two assets. The easiest way to explain this is to look at stock indices. If the Dow Jones rises, the DAX very often rises too . The situation is similar to other assets such as EURUSD and GBPUSD or crude oil and heating oil.
Examples of synchronization
Dow Jones and DAX
EURUSD and GBPUSD
Crude Oil and Heating Oil
So if you find a good trading spot in the Dow Jones and open a trade in compliance with your own money management requirements and then simultaneously open up another trade in the DAX, then this leads to an increased risk.
Correlation increases the risk
If you have 2 or more trades that are going to be very similar, then, of course, this is great if all trades are going in the right direction. But it gets dangerous when the trades are not going so well.
Suppose we risk 1% per trade, and both trades are not going well. In this case, the risk increases to 2%. At this point, you must not make the mistake to evaluate each trade individually. The correlation was and is known. This correlation is responsible for increased risk and should be considered and managed.
How to avoid correlation?
Correlation, and thus an increased risk, can be easily avoided with 2 procedures. For one thing, you can simply halve the positions to have a total risk that is consistent with money management. Another option would be to choose only one of the spots; usually, the spot that looks more attractive.
Correlation coefficient as a tool
Correlation can be seen relatively clearly with a look at 2 charts. A somewhat more advanced way to display the 2 charts is in a 1-chart image. So we have shown it in the upper part with 3 examples. Nonetheless, such representations involve a certain amount of subjectivity that we wish to exclude as much as possible.
An objective way of representing the correlation is the correlation coefficient. The correlation coefficient is displayed in the form of a number between -1 and +1. The meaning of the number is very clear:
- +1 means 100% positive correlation
- 0 means that 2 values do not correlate at all
- -1 means 100% negative correlation
Ideally, one only has trades that correlate little with each other. We deliberately ignore the term hedging.
Presentation in a chart
The following chart shows the correlation coefficient based on 20-day candles for Dow Jones and DAX:
You see an indicator marked CC in the lower area. This is the correlation coefficient. At the chart end, it stands at around 0.9, which represents a 90% positive correlation. Of course, this value is not carved in stone and changes over time. So it pays to check these things over and over again in the timeframe you trade the most. The more periods you take, the smoother the appearance of the indicator.
Sources for the correlation coefficient
Sources for this correlation coefficient are many, and we like to use TradingView to get an overview, but some other trading platforms also offer this tool.
