From the June 01, 2010 issue of Futures Magazine • Subscribe!

Correlation trading: Opportunities and tactics

Price action often emulates wavelike forces in nature. Throw a pebble in a lake of water, and the calm waters turn into relatively low amplitude waves that propagate the water. Throw several pebbles from different directions and the surface turns into a cross section of wavelike interferences and displacements that eventually revert back into equilibrium. Like the thrown pebbles, words, as well as economic events, become forces that disrupt the medium of market prices. The erupting Eyjafjallajškull volcano in Iceland, the Greek sovereign debt crisis, and speeches of Ben Bernanke, Axel Weber, and other central bankers act like those pebbles in the forex global sea. The results are sentiment waves that spread throughout the market. The patterns are also very similar to chemical reactions called reaction diffusion equations, like mixing an acid and a base. There is a sudden reaction, heat energy is released and then the reaction diffuses. Most of these forex reaction patterns are short-lived, but some provide ample time for opportunities to play a reversion. These can be recognized when correlations in their movements with other pairs become significantly skewed. Let’s look at a few opportunities.

Chart

The AUD/USD and the EUR/USD have been highly correlated for more than a decade, but “See ya later sucka” (above) shows how that correlation broke down as Australia emerged from the global recession early, while the Eurozone debt issues intensified. Correlation data measuring the co-movements of these pairs had a peak of 72% correlated in October 2009, with correlations going down lately below 55%. This divergence in correlations provides an opportunity to play the spread narrowing between these pairs. This can be done in many ways. One can sell the AUD/USD and buy the EUR/USD. More directly, one can sell the Aussie against the euro (AUD/EUR). As we observe in “Crikey mate" (below), this crosspair is positioning for a major retracement.

Chart

You could play a reversion trade using options with DualCurrency European Digital Option, where the payout is made if two conditions are met. Constructing such an option would involve a bet that the AUD/USD would be below a price point and at the same time the EUR/USD would be above a certain price point by a certain date. This trade is not usually available through a retail platform but illustrates the scope of tools available to trade currency spreads.

The sovereign debt crisis in the Eurozone has caused additional disconnects in typical patterns. A major disconnect in the co-movement of the EUR/USD and the Brazilian Real (BRL/USD) is another. The Greek debt crisis caused risk aversion to spill over to emerging markets. This philosophy led to a widening spread between the EUR/USD and the BRL/USD. Keep in mind that the Brazil central bank increased rates on April 30 by 75 basis points to 9.5%, attracting more demand for the real as a carry trade currency. The global crisis has provided support for the U.S. dollar as a global reserve currency of last resort and it appears that the euro became the new popular short in carry trades. The Greek crisis only added to euro weakness. However, the traditional relationship in this pair should emerge as the global economy rebounds.

For traders with a further taste for emerging market currencies, the Mexican peso (MXN/USD) and BRL/USD pair has experienced a sharp divergence in its movements.

When considering correlation-based strategies, traders should look at extended periods of time to identify “normal” patterns. Understanding what is causing the divergence in typical patterns is important. There is a saying that goes, “markets can stay irrational longer than you can stay solvent,” so it may be best to wait for the market to begin to move back in line before initiating a reversion trade.

Abe Cofnas is the author of the forthcoming book “Sentiment Indicators” (Bloomberg Press). He can be reached at abecofnas@gmail.com.

About the Author
Abe Cofnas

Abe Cofnas is author of “Sentiment Indicators” and “Trading Binary Options: Strategies and Tactics” (Bloomberg Press). He is editor of binarydimensions.com newsletter and can be reached at abecofnas@gmail.com.

Comments
comments powered by Disqus
Check out Futures Magazine - Polls on LockerDome on LockerDome