Correlations to Consider When Trading Financial Markets

 

Hello there, this is tradingpedia.com, and this video deals with correlations when trading financial markets, the currency markets, and not only. You have to remember that in a trading account there are other markets offered too, like stock indices, CFDs, etc., and they trade in a correlated manner. In this video I would like to introduce a few correlations to consider.

Trade Major Forex Pairs, or Minors

To start with, consider the difference between majors and minors. They refer to currency pairs. Any currency pair that has the USD in its componence, e.g. EURUSD, USDJPY, USDCAD, is a major. The other ones are called minors.

Depending on the broker, you may see further differentiation between currency pairs. Some minors are called exotic currencies or exotic pairs, but this is the main difference between them – majors and minors.

Minors are also called crosses, or cross pairs. These crosses have in their componence two currencies other than the USD and move on the differences on the two majors. For instance, this is the USDCAD weekly chart – a major pair. What would be a cross based on the CAD?

Let us say that this would be the NZDCAD if the other two major pairs, e.g. USDCAD and the NZDUSD, move in a similar manner, percentage wise, the cross remains flat. If the USDCAD rises 1% and NZDUSD falls 1%, the NZDCAD will not move. In other words, you can trade one of the three currency pairs based on the differences on the other two pairs. This is the most important correlation to consider when trading the currency market.

Risk-on/Risk-off Markets

Another correlation to keep in mind is the risk-on/risk-off markets. So keep this in mind, as risk-on refers to the stock market that rises. Because the stock market is riskier than investing in fixed income products like bonds or notes, when investors move money into the stock market it is called risk-on. Traditionally risk-on moves on a higher stock market in the United States, e.g. Dow Jones, Nasdaq, S&P500. When they moved to the upside, investors used to borrow in JPY, because it had the lowest interest rate for decades, then they used the JPY proceeds to buy USD to pay for the stocks, creating a risk-on move. The Dow moved higher, USDJPY higher too, and the JPY pairs to the upside based on the direct correlation.

That changed lately as interest rates all over the world came to the zero level due to the Great Financial Crisis in 2008-2009, then the sovereign crisis in Europe with the Greece problems, then the ECB lowered the deposit facility below zero, so with low interest rates investors found different alternatives to the JPY. Nowadays, a risk-on move refers to the stocks moving higher, AUDUSD, EURUSD, GBPUSD higher too. This is an important correlation because if you believe that the market is on a risk-on move you should not trade all the currency pairs on the same direction. Trading the same volume on all pairs is like trading the same position on different markets – you end up overtrading and the slightest move against you will affect the trading account.

The opposite is true on a risk-off move – the stock market declines, gold to the downside, like it happened recently, the EURUSD, AUDUSD, fall, USDCAD rises, etc.

Commodity Markets

Then are also correlations with the commodity markets. Commodity currencies react strongly to the market moves in the commodity they represent. For example, the Canadian dollar is strongly correlated to the price of oil. Canada has an energy intensive economy and a big part of its GDP depends on the price of oil. Changes in the price of oil affects the Canadian dollar and all the CAD pairs.

For example, this is what happened with the USDCAD in March and April when oil dipped into negative territory. If you remember, the futures contracts on the WTI in April with expiry in May had no buyers suddenly – it was no demand for oil due to economic lockdown. Therefore, it was no bid on the oil market, oil closed negative, the clearinghouse accepted that price, and that sent the CAD lower across the board – lower oil, lower CAD, higher USDCAD.

To make the most out of these correlations, especially the ones related to commodities, look at reports like the oil inventories in the United States as they affect the price of oil, OPEC meetings, etc. Anything that affects the price of oil has an impact on the Canadian dollar.

The price of oil has an impact on the currency market because oil is a big driver for inflation. Last but not least, consider oil and inflation correlation. How come?

Higher oil prices lead to higher inflation, higher inflation leads to central banks raising interest rates, higher interest rates are positive for a currency. End the opposite is true with a lower oil price.

Thank you for being here and let us move on to the next video. Bye bye.