How to exploit and profit from market correlation

In the forex market, we often discuss the concept of correlated pairs. This is because, inevitably, a currency must be paired with another currency to determine its relative value at any given point. In the futures market, this value is derived from the dollar because it is the reserve currency of the world and has been since 1944. We can use the pair’s phenomenon to forecast, with some reliability, the market direction on any given day.

The relationship in play is market correlation. Our approach here helps answer the age-old question of whether a particular day is a good trading day — or not. Too often, we note at some point during a trading session, “This is a great trading day,” or “Why did I even bother?” Here we’ll attempt to show how these relationships play out together and which ones are exploited more easily for profit.

In a good trading day, related markets are expected to rise based on the relevant fundamentals. Traders seeking to take advantage of this relationship will place long positions in the appropriate markets. On the other hand, during bad trading days some markets are ripe for short positions, or they should be avoided altogether as these relationships tend to be less predictable.

What makes a “good” trading day good? First, the trends typically tend to be less volatile and more reliable. When positively correlated markets are rising, they often do so in a more controlled fashion. What are here termed “bad” trading days also can be profitable if accommodating positions are put in place; however, the profits are less reliable and the risks are greater. Simply put, profits are easier to come by for traders, particularly those with less experience, who focus on exploiting bullish tendencies rather than price breaks lower.

Fundamental ties

A trader can view the futures market prior to market open (pre-market) and get a sense, using key fundamental relationships, to detect the underpinnings of a good trading day. Once a day is identified as a possible good (or bad) trading day, you know how to approach it. Either you will press your advantage as trends develop, or you will sit on the sidelines and wait for a safer opportunity.

Keep in mind that trading days can change. Just because a day sets up well doesn’t mean it will stay that way. Many things can happen during the course of a trading day; for example, a geopolitical event can occur without warning. Seeing this and changing course if need be, though, is all part of being a trader. Your immediate goal is recognizing key fundamental relationships that can set the tone.

Four strongly related markets for determining that tone are financials, crude oil, stock indexes and metals. By financials we mean the U.S. dollar and the Treasury bond markets. By stock indexes, we are referring in large part to the S&P 500 and Dow Jones Industrial Average. By metals, we are referring to gold.

The directional relationships between these markets, and which movements compose each day type, are shown in “Pick your days wisely” (below).

Markets in charge

It’s helpful to understand a bit more about these markets.

The U.S. dollar is the world’s premier currency and has been since the Bretton Woods Agreement of 1944. At that time, it was determined that all countries party to the agreement would peg their currencies to the dollar. The dollar’s influence was so strong that it maintained its status as the world’s reserve currency even after President Nixon decoupled it from gold in the 1970s. Prior to Bretton Woods, the British pound sterling was the world’s leading currency. At the time, the United States was becoming the world’s preeminent super power, and the dollar was backed by the full faith and credit of the U.S. government.

Crude oil is a commodity that affects everyone. Each time you pay a visit to the gas station, you become aware of crude oil’s economic conditions. Crude oil also is considered a barometer of how the overall economy is doing. All else equal, rising crude oil prices mean economic activity is increasing and expanding, and falling crude oil prices suggest the opposite. As consumers, we cringe at the idea of increased gasoline prices, but economically speaking this is the message. Consider a side-by-side view of crude oil and the Dow. When both are going up, it is quite often a good trading day in the making.

Stock indexes measure the overall gain or loss on any particular trading day. The S&P 500 and the Dow Jones Industrial Average are the two most-widely followed proxies for the market as a whole. For most traders, these are the markets in which positions are placed.

Metals are timeless stores of value. Gold, historically speaking, has been a hedge against inflation and often has been viewed as money of last resort. In recent years, it has served its purposes as a safe haven, built on the notion that if all else fails, there’s gold. In recent months, the fear factor prevalent in the economy has weakened, and so has gold. However, when Cyprus was falling apart, and it looked like the European Union was in danger of a breakup, gold went to highs not seen in some time. 

Keep in mind that this trading day analysis is rooted in the futures markets, which offer much greater leverage and deep liquidity. In addition, there is no thought or concern about earnings shocks, earnings reports, company malfeasance, etc. Even if you are a stock trader exclusively, this analysis affects you. If you own or trade stocks of any kind, they can be affected by the overall market, and understanding the impact of interrelated financials and commodities can give you an edge.

Analysis examples

Putting this knowledge to use is relatively simple. Watch the relevant markets closely; a five-minute chart works well. As trends concurrently develop, look for prices to move in the directions indicated in “Pick your days wisely.” Once the listed moves develop and appropriate trends are established, look for an opportunity to get on board.

“Inverse relationship: Dollar and crude oil” (below) shows the U.S. Dollar Index on March 14. At around 8 a.m. (identified by an arrow on the chart), the dollar hit its high for the day and then proceeded to decline in value. At the same time, the April crude oil contract made its low for the day and then increased in value. This inverse relationship between the dollar and crude oil is a powerful one. Early in the trend, astute traders recognized the move developing and placed positions to exploit it — most likely as long trades in crude oil.

“Bad day rising: T-bonds and E-mini S&P” (below) is an example of a “bad” trading day when T-bonds rise and stock indexes fall. However, fast-acting traders could have made money on the short side, particularly in a market as liquid as the E-mini. At about 8:10 a.m. on May 20, the bond futures hit their low for the day before rising. While bonds were rising, the E-mini was decreasing in value. This trade could have led to a profit of 12 ticks, or three full points.

Many traders are drawn to the markets because they value one thing above all else — freedom from economic servitude. We seek a way to earn a living as a trader. Even if you maintain a day job, knowing you have an alternative means of income gives you the confidence to be decisive, pro-active and operate from a position of strength, rather than be hamstrung by fear. Knowing how to trade both good and bad trading days is a step toward conquering that weakness.

Nick Mastrandrea is the author of Market Tea Leaves, a free daily commentary that focuses on market correlation. You can reach him at www.markettealeaves.com.

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