From the July 01, 2011 issue of Futures Magazine • Subscribe!

Avoiding correlation surprises

Gold and the U.S. Dollar Index is in near perfect negative-correlation most of the time, but look what it did for nearly three quarters in 2010. "Best buddies," (below) shows not only that the dollar and gold aren’t always polar opposites, but sometimes move together.

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Even with today’s powerful correlation platforms that try to give traders confidence, they miss the fact that just because a correlation exists or existed over time, they can and do change. There will be times when these strong correlations even may reverse.

Commodity traders can be misled easily by using correlation studies. An example is a trader who does a correlation study on the euro and Swiss franc. These currencies can be negatively correlated 95% of the time. However, when market volatility increases and the U.S. dollar strengthens, they become highly correlated.

These types of correlation flips can be fatal for the arbitrageur highly leveraged in similar markets, but also can be dangerous for the trend-follower adding risk based on the belief that he has a well diversified portfolio. Trading a diversified group of markets allows a trader to take on more risk than if all that risk capital was concentrated in one market or one sector. Diversification, however, implies non-correlation and, as correlations change, so does the level of risk.

David Ricardo accumulated a fortune through trend-following in the 1700s. He had several simple trend-following rules: Never refuse an option when you can get it (identify via relative strength markets that seem to be trending), cut short your losses and let your profits run on.

Ricardo’s idea of using relative strength can help traders identify which markets to trade. Relative strength is identifying the strongest and weakest trending markets and can be determined by rate of change. Each market has a score, making it easy to identify the weakest and strongest. This could become your universe for trades. As opposed to trading a group of non-correlated markets in a trend-following approach, you can pinpoint your best options using the relative strength method.

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