The logic of the movement of correlated financial instruments is successfully used in trading, especially in managing investment portfolios. Correlation is based on a causal relationship, which makes it possible to predict the direction of prices with a high probability. It is used to adjust risk management and optimize profits.
Correlation can be positive (direct) when the quotes of correlating assets change in the same direction, as well as the reverse when the directions of changes in the quotes of correlating instruments are opposite. It is the reverse correlation that can satisfy the maximum demands of the trader, both in terms of profitability and in terms of hedging risks and minimizing possible losses.
The most striking example of correlation is Gold (GC) and Silver (SI), Oil (CL) and Heating Oil (HO), SP 500 (ES), Nasdaq (NQ), and Australian dollar (6A) with the New Zealand dollar (6N). The divergence of these instruments can be used for pair trading, or you can trade a less liquid instrument for convergence, in case it deviates from a more liquid one.
A good example of an inverse correlation can be the Japanese Yen and the Nikkei225 stock index. If the Yen becomes cheaper (due to the soft monetary policy pursued by the Bank of Japan), the index rises and vice versa. As the value of the yen strengthens, the index declines. This is due to the fact that investors try immediately invest in cheap currency and mainly buy shares of companies, and when its value grows, investors want to have an expensive national currency (cash) in their assets and sell shares.
Some currencies are pegged to commodities, such as the Canadian dollar, whose value depends on oil prices. The more expensive oil, the more expensive cost of the Canadian dollar, this is a direct correlation. This relationship can also be used to hedge risks. For example, with an opened long position in oil, the price does not move in your direction (it becomes cheaper), then it is advisable (instead of fixing a loss) to simultaneously open purchase of the same volume for the USDCAD currency pair. With a decrease in the cost of oil, the value of the Canadian dollar will decrease, and the cost of the American dollar will rise in price, respectively, there will be an upward trend in USDCAD.
The classic strategy based on the correlation of currency pairs is that in the event of a sharp deviation of the correlation coefficient from the current value, transactions are opened in the direction of restoring this value. Using the "Multichart" function, we plot the main currencies on the chart. We calculate the most expensive currency and buy the cheapest one for it.
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