Using Correlation in Trading

Price movement can be easy to trade in the financial market if we know just what the price is about to do. Understanding the general idea of what a particular currency or group of stocks is about to do is what correlation is about. Correlation works perfectly well in any kind of market, be it in stocks trading or Forex trading. I will lay more emphasis on forex trading in this article.

Using correlation to trade can give the general idea of what a particular currency to trade and which of the pairs will give less trouble if traded. The idea of correlation is to check price movement for pairs that do if not the same thing, but almost the same. The price of correlating pairs can move in the same direction or opposite direction depending on where the currency is in the pair.

Let's take, for example, the NZD currency pairs correlate perfectly well in the market. The same thing goes for other currencies as well. Pairs will NZD as the base currency e.g. NZDUSD will move according to the strength of NZD, i.e, if NZD is strong, the price of the pairs will rise. While pairs with NZD as counter currency e.g. EURNZD will do the exact opposite of what the NZD currency is doing, which means if NZD is strong, the price of this particular pair will drop.

The idea of using correlation to trade is to get the flow of the market. Which currency is moving and which of the pairs will be easy to trade. It is not advisable to trade all the pairs with a particular currency because you might be overtrading by doing that, but when selecting the best pairs to trade, correlation is very useful.

When using correlation to select the best pairs to trade, some pairs are faster than the other and this can be used as an edge for you. Like I said earlier, you do not have to trade all the pairs. The ones that have fast movement are called the Leaders, and you might want to keep an eye on them. Once the leaders move, the Second leaders are preparing to join the first leader. You might use this to your advantage and get on the second leader in the currency group because they will definitely do what the first leaders have done. The price movement can be quick but they move pretty well.

The third category is the laggards. These are the pairs that are lagging in price movement; it might be due to the strength of the currency in the pair. Once you identify the first leader and the second leader, the laggards are not so difficult to identify because their movement is being delayed. The price movement on the laggard pairs will be slowing down and will have much distance to travel. You can also use this to your advantage and get an entry on them.

Of all the three categories in using correlation to trade, the best ones to pick are the second leaders, The first leaders have already initiated the currency movement and in most cases, they give less entry. To catch the turn of the price on the first leader requires a high level of anticipation. But the second leaders give a good entry and also have a fast movement like the first leaders. This can be a no-brainer trade to you as a trader by just watching what the first leader is doing. The laggards are the least because they travel less distance compared to the first two categories. What I meant by less distance is in the number of pips they give.

Do not forget, as you use correlation for entry, you can use it for the exit too. If the price of leading pairs is reacting at a particular S&R area, you might want to exit your trade when it gets to the nearest S&R area.

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