What’s The Market Correlation?

2020-05-28 | Simpler Trading Team

Traders are always searching for clues in the markets to show them where the next best trade may be waiting.

Borrowing a clue from the futures trading world can help traders in options and stocks. Futures trading regularly takes a look at the larger picture “correlation” between markets to identify potential trade setups.

Correlation measures how securities move in relation to each other. Asset classes, like foreign currency or transport stocks, can have positive or negative correlations. Understanding how one asset class moves in relation to another helps gain perspective on market movements on a large scale.

Here’s correlation simplified:

  • A negative correlation between two securities implies that as one moves up, the other moves down
  • A positive correlation between two securities implies that as one moves up, the other moves up with it

Correlation helps show not only how markets move, it also shows the greater moves behind the scenes. Instead of only focusing on one specific trade, correlation helps develop a grasp on the overall market view.

It helps to have some examples of correlation.

As an example, if the Japanese Yen is spiking, that is typically a heads-up for traders that S&P stocks could begin trading lower. This negative, or inverse correlation, means the two markets typically move opposite of each other.

The Euro and the U.S. Dollar typically have an inverse correlation as well. This means that strength in the Euro generally translates to weakness in the Dollar.

Another example of correlation is how transportation stocks generally positively align with the U.S. stock market. When transportation companies are doing well, this is good news for the overall market. Customers are taking trips, shipping packages, and traveling. This correlates to disposable income and is a signal of a move higher in stocks.

Like any tool used in trading, assessing correlation provides insight into understanding how the broader markets work but it isn’t a magic bullet.

Correlation between asset classes can change over time and is best combined with specific market analysis. Correlation can be used for specific trade setups or simply as a “heads-up” for trades already in play. To spread the risk around your portfolio, correlation can help keep you from having too many trades in one asset class.

Correlation allows traders to understand how the market is connected, to confirm moves, and to understand overall market organization.

We Saw: Stocks play nice, then unwind lower at the close — 

  • Market concerns rise over U.S.-China trade
  • Oil kicks into gear with gains due to demand rising
  • Tech, software stocks showing strength

We’re Watching: … S&Ps showing bullish muscle —

  • Continued market rally to add to positions
  • Markets stumble, but Dow holds above 25,000
  • Plays in: SPY, UNH, NVDA, EA, CWH

Does it make sense to “see” price moves before they happen? Learn about catching “pops and drops” in a volatile market.