Have you ever noticed a time when a certain product went up and another similar product went down at around the same time? Or when that product went down and another product also went down at the same time? If the answer is yes, then what you noticed was 'product correlation' in action.
What exactly is product correlation? In the financial markets, correlation is a statistical measure of how two products move in relation to each other. Product correlation tells us whether two products tend to move in the same or opposite direction or whether they move completely independently of each other without any discernible pairing pattern over a specific period of time.
Let us look at an example from a Forex (currency pair) trade (visual chart examples further below): If EURUSD goes up and USDJPY goes down, this is called a NEGATIVE correlation and if GBPUSD goes down and AUDUSD also goes down, this is called a POSITIVE correlation. When trading forex in particular, it is vital to remember that since currencies are traded in pairs, no one currency pair is ever totally isolated. Therefore, if you plan on trading more than one currency pair at a time, it is very important to understand how different currency pairs move in relation to each other. Correlation also applies to other types of products such as gold, silver, stocks and indices.
Let us take a more detailed look at how correlation is worked out. Correlation is computed into a number known as the "correlation coefficient". This number ranges between -1 and +1: •Perfect negative correlation (an exact correlation coefficient of -1) means that the two respective products will move in the opposite direction 100% of the time. •Perfect positive correlation (an exact correlation coefficient of +1) implies that the two respective products will move in the same direction 100% of the time. •If the correlation is 0, the movements between the two respective products are said to have no correlation and their movements are completely independent from each other. In other words, there is no way to predict how one product will move in relation to the other.
POSITIVE CORRELATION
NEGATIVE CORRELATION
PLEASE NOTE!!! Although correlation exists in the financial markets, it is NOT set in stone as a guarantee. Firstly, the correlation coefficient between products in the financial markets is rarely, if ever, at +1 and -1. Secondly and more importantly, every individual product has its own UNIQUE supply and demand measures and also has buyers and sellers that have their own UNIQUE motivations and goals in relation to that specific product. When a product goes up or down, this does NOT necessarily mean that it will always follow in line or go the opposite way to another product.
This is a very useful and easy to understand explanation about the nature of correlation between different instruments. Thank you. I look forward to further educational content from your group.
BluetonaFX
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@Kibishii, We appreciate your comment, thank you. There will be plenty more to come from us, stay tuned!