How to trade correlated markets

|23rd April 2015|

Most traders will understand what is meant by market correlations yet I have come across very few traders that actually use them to their advantage and ultimately profit from them. If markets are correlated it simply means that at one market goes up/down then another market will follow, they can also be inversely correlated meaning that if one market goes up/down the other market will move at the same time but in the opposite direction. Correlations are great because if you can see a set up in one market it can point you in the direction of another set up within a market it is correlated with. 
Getting an edge in the markets can be hard for a private traders, and missing out on opportunities can be very costly over the long run. So why is it that correlations are not more widely used by traders as part of their trading plans? Well that’s simple, it’s because they don’t last forever. Markets that are correlated today may not still be correlated in 6 or 12 months’ time and even if they are, it may be less effective at that time, making spotting them consistently and trading them quite hard. 

Over time many traders will develop an understanding with the markets they trade and which of their markets are correlated, but trading that correlations can still be tricky. The way I like to trade correlations is by using COT data to confirm the strength of the correlation first, before then looking for a chart signal. The US dollar is one market with many active correlations because of its significance in world trade and if you can find a market strongly correlation with it, it can be just the trigger you need to take action.

One such recent example is crude oil. I have heard many traders talk about trying to pick the bottom in the oil market during its decline since last July, however as one of the contributing factors in oil’s decline was the increasing strength of the US dollar during the same period, I have kept a very watchful eye on the COT data for oil as well as for the US dollar to give me an indication of when oil could reverse. Prior to the turn in the price of oil in mid-March, there had been a slow and steady increase in buying as oil approached $40/barrel but I wanted more confirmation before seeking a bottom. As oil and the US dollar are inversely correlated, high levels of selling in US dollar combined with high levels of buying in oil, was the correlated signal I was looking for. The charts below shows we got both a few weeks ago along with a reversal chart pattern, providing the full confirmation I was looking for. 
              Figure 1.1, Crude oil and US Dollar correlated COT signal. 

Taking this a step further, knowing CAD and oil are also correlated markets due to the large exports of oil from Canada to the US, and that a weakening US dollar would see a decline in USDCAD, these factors focused my attention on this market as well. As a bottom was formed in crude oil, so too was a top formed in USDCAD, leading to both markets breaking resistance and support respectively on exactly the same day.

Figure 1.2, Crude oil and USDCAD break resistance/support

It doesn't matter how you get an edge in the market just as long as you do. Spotting correlations and knowing how they will impart other markets is great, having proof of the correlation and taking action on it is even better. If you're confident you already have an edge over the market then stick with it, if you're one of the many traders that don't, be on the look out for correlations.

By Ray Gilmour