CORRELATION,DIVERSIFYING & HEDGING: An elementary viewGreetings
In the world of forex trading or trading of any financial instrument for that matter, many complex, technical and convoluted words are thrown around in conversations. Such jargon, though is relevant, tends to result in many blank stares especially among some of my peers, many of whom are not finance, economics or statistic fundi's. Many of them with basic education, yearn to be part of these conversations and also contribute their own opinions. This leads to many of them simply offering that awkward nod, wide smile and occasional laugh when everyone else does. they are relegated to conversation observers who's feet seem stuck to the floor. I've been there and that feeling is gut-wrenching, degrading and leads you to view the rest of the crowd as snobs, elitists or braggarts. this then creates apathy toward the subject matter. Well i will try, through this article, to open one of the many back doors to this world. I will attempt to unwrap and "break it down" to bite size chunks so that maybe one day when you are in the midst of the so called "esteemed highbrows", you will also throw in your "two cents".
This article will explore the concept of correlation trading. Correlation can also be viewed as the interconnection, interdependence, association or link between. So correlation trading (especially in forex), is basically a statistical measure of the relationship (or association or interdependence) of currency pairs. A simplified example would be if you take the AUDJPY pair. This pair is an association or link-between the AUDUSD and the USDJPY . It would stand to argue that the AUDJPY pair is "correlated" to the AUDUSD and USDJPY. A negative correlation implies that the currency pairs will move in opposing directions while positive correlations tend to move in the same direction. Negative correlated pairs are usually used for hedging purposes. Correlation coefficients range from-1 to +1. A correlation of -1 implies that the two currency pairs will move in opposite directions every time and vice versa if the coefficient is +1. In the past, at this stage of the conversation, I would have switched off looking for how to exit the group, but read further as we further dissect this further. What i have come to appreciate is that you don't have to fully get it the first time, but it will make sense as you progress.
So correlations are usually tabulated and presented in different date ranges, namely daily, weekly, monthly, 6 monthly and yearly. A simple example of the EURUSD against USDJPY pair would look like:
DAILY +0.44
WEEKLY -0.42
MONTHLY -0.34
6 MONTHLY -0.55
YEARLY -0.85
interpretation
Over a period of one year the EURUSD had a strong negative correlation against the USDJPY , meaning that 85% of the time when the EURUSD went up the USDJPY went down. Conversely over the daily time period these pairs were positively correlated. This example was also deliberately drawn up to show the correlations do not always remain the same over time. From the example the effects BREXIT might cause the temporary positive correlation on the daily time range among many other economic factors taking place in Japan.
SHOW ME HOW TO MAKE FROM THIS!!!
Now we have some understanding of correlation in forex pairs, here's how the "mashed potatoes mixes with the gravy". We know that the EURZAR and the USDZAR have a very strong positive correlation(I am biased on ZAR: South African Rand since i'm the mother continent), so trading trading on both pairs might not be advisable as it simply doubles your exposure. For instance you buy 1 lot of EURZAR and the same on USDZAR , knowing that these pairs are likely to move in the same direction, will simply double the chances of you losing more if the trade goes against you and vice versa. Lets say you try to get a "one up" on the market like what i tried to do when I started trading by going long on EURZAR and short on USDZAR at the same time. Well my friend that is a contra-trade (a trade that cancels the other) and most of the time you will end in a loss. You might be asking how you will end in a loss if the trades cancel out each other, well firstly these pairs don't always move in the same exact pip range (because they are not 100% correlated) and they have different pip values. Trust me the math doesn't lie, I won't go into it i might lose you at this point. However pairs that are negatively correlated to the EURZAR like the ZARJPY should not take an opposite position. Since we know that when the EURZAR goes up the ZARJPY goes down. So buying (or going long on) EURZAR and selling (or going short on) ZARJPY is the same as buying two position of EURZAR . In other words we have doubled our risk.
Some people might say well that the disadvantages stated above can also be utilised to our benefit if we know how to hedge our trades and also bring in diversification. Now this conversation is the one where we graduate to the master class of the inner circle of trading pro's. a friend approached me and enlightened me to the fact you can also diversify your trading portfolio, especially if you have a directional bias on a particular pair. Say, for example, you believe that the ZAR is entering a bullish season, you can diversify by putting a buy(going long) on EURZAR and USDZAR knowing fully well that the American economy has a different bias than the European monetary authorities, therefore by spreading risk between EURZAR and USDZAR will lower losses if the USD goes in the opposite direction quickly, allowing you to adjust your portfolio. This learned friend of mine went on to explain that for pairs that are negatively correlated, like the EURZAR and the ZARJPY can be used for hedging purposes through the use of the different pip values ( PIP is the smallest move in the price of a currency pair). Hedging is the opening of a position with the purpose of offsetting any gain or loss on the other transaction. Assume the value of the pip move in EURZAR is $10 for a lot of 100,000 and the value of a pip move in ZARJPY is $8 or a lot of 100,000. Knowing this can help us hedge our exposure to EURZAR . (Please be aware that certain countries do not allow hedging)
Let say i open a position of 1 short EURZAR lot of 100,000 units and 1 short ZARJPY lot of 100,000 units. When the EURZAR increases by 10 pips, the 1 would in a loss of $100 (number of PIPs X Value per PIP). However, since ZARJPY moves opposite to the EURZAR , the short ZARJPY position would be profitable, nearly up to $80 (this is due to the strong negative correlation). This would turn the net loss of the portfolio into just -$20 instead of the full $100. On the flip side this hedge also means smaller profits in the event of a rally down in EURZAR . However, in the worst-case scenario, losses become relatively lower.
CONCLUSION
All traders regardless at which stage you are, from novice to grand-master, there is need to have an appreciation of correlations and how they affect your portfolio. work towards:
1.Eliminating contra-trades (Trades that cancel each other out)
2.Diversify Risk. By not putting your eggs in one basket. By taking advantage of the imperfect correlations, one can open two positions in the same direction knowing that you limit your exposure to one pair.
3. Potentially double up on profits. In our example above, the high correlation between EURZAR and USDZAR , would mean that if you open a position one of the pairs you can open a similar position on the other pairs thus potentially doubling profits and vice versa.
4. Hedging. This usually results in lower profits, but it also minimises your losses.
5. Confirm break outs and avoid fake outs. Although I did not discuss this aspect in this article, it is the very topic that will be in my next article that i will be releasing next and will sure be topic that will result in all those finance and economics gurus offering you a 2 minute attentive silence, as they nod their heads to your insightful analysis of the markets. You might even get a "let's chat later privately and explore this in depth, or that's exactly what i was about to say". This will leave you walking a little taller, with a bounce in your step, calling shots. All i am saying is if i can do this, surely you can too.
Takunda Mudenge is a market analyst based out of Zimbabwe, Africa. He writes in his personal capacity and the information is purely for educational and entertainment purposes and should not be construed or assumed to be investment advice.
The information above was collected from various investment websites and literature and all attempts were made to make it into contemporary English.
