Commander in Pips: Since we’ve discussed what correlation is, let’s try to investigate how it could be applied in trading. Sounds interesting, but its application still limited, mostly due to the huge USD role in all Forex transactions. Still, I will provide you with one advanced idea, that maybe you will find useful sometime. But our start point will be thoughts of common sense about correlation.
Commander in Pips: The obvious ideas of correlation application that we’ve discussed in previous part are as follows:
1. Exclude misunderstanding of diversification and eliminating of almost offsetting trades. For example, now you know that long position on EUR/USD and USD/CHF simultaneously has not much sense and could be treated as blank and counterproductive. Although previously you may have wrongly treat it as diversification and risk reducing;
2. Taking into account correlation, you still can diversify your positions. For example, you have long EUR/USD position and want to scale in. Since you know correlation ratios as with GBP/USD as with USD/CHF or other pairs – you may not necessary add another lot of EUR/USD but open long Cable or short USD/CHF. This will add some diversity to your overall position. Besides, if some pair will move faster in your favor – you’ll get more profit. That is also a specific way to use leverage.
3. The same could be done with risk. For example, you make an analysis of US Dollar index and come to conclusion that it should rise soon. Still you want to eliminate the impact of intrinsic problems of other currencies and are not sure about what pair will give you more profit. So, you may diversify your position based on correlation – enter short not just 3 lots of EUR/USD, but, say, 1 lot EUR/USD, 1 lot GBP/USD and 1 lot long USD/CHF. In this case, if, say, some improvement in the EU will happen – the other pairs will continue to move in favor of the dollar and will give you acceptable overall results.
4. Risk hedging. This is the topic of our advanced discussion. Although the surface thought is that you may lock your position by another pair with high correlation – it’s not so simple. The point is that two pairs could have and much of the time do have different pip value. Also in the short-term, correlation is a subject to change and not so stable, so pip value also will fluctuate. But in general, let’s suppose that you intend to enter long EUR/USD, but are not sure from which level. You have two possibilities – enter long with part of position and add more later, or enter with normal size but combine it with a long USD/CHF position lesser size. This will give you some advantages. First – the pip value will be different, so you may do fine tuning of your position value, based on overall risk that you intend to take at the first entry point. Second, when and if the market will reach your second entry point – you can close USD/CHF position and get some profit on it. But this is a simplified understanding of hedging. Real procedure we will explain later in this lesson.
5. Correlation gives you a confirmation tool of different breakouts and trends. Since you know what pairs are highly correlated between each other – you may use their price action to judge about the truth of some breakouts or trends. For example, if the EUR/USD starts to rise significantly, but Cable and USD/CHF stay flat and do not support this run – then, probably this move is mostly due to EU news or events and has no relation to the USD. This could lead to possible reversal on the EUR/USD after the market will adapt to the news. So, if there is no agreement in highly correlated pairs’ movement – this should be a sign that this run on a particularly pair could stop soon. If you still want to trade it – reduce your lot size.
6. Finally, correlation is subject to change when you do not wait it. Indeed, correlation is different each time that you calculate it. It could be high during the recent week while it could be less during the previous 3 moths. So, you have to update correlation data regularly, if you will use it.
Advanced talks on correlation
Commander in Pips: I know that you like statistics. You are a fan of the volatility calculation and now correlation calculation also, right?
Commander in Pips: Ok, then I'll start directly from the point. There is some theory that exists by the name of its creator, but usually it is applied to the stock market. It is called Markowitz theory. I will not dive in yp the wide details and will just tell you the core. If you are interested in it – you will find a lot material about it on the net. The major idea is that risk of investment is with return on of investment – the higher the risk the higher the return. Risk treated as volatility of some assets. And theory tells us that there is a possible way to create an investment portfolio from N different assets that will give you optimal relationship between risk and return – a so called “efficient portfolio.” All others combinations of these assets will give either less return with the same risk or higher risk with the same return. We can try to adopt this theory for forex market.
Commander in Pips: Hold on, this is not as difficult as you can imagine. We will use a simplified example just for two currency pairs, and calculate the ratio of lot size that will give us the maximum return with predefined risk. Here is our task:
1. Find the pair with maximum carry;
2. Find another pair with small correlation and minimum carry.
3. Combine them so, to get better risk/reward ratio.
This is just an idea and example that use just two different pairs. In reality you can use as many pairs as you can, if they significantly improve your risk/reward ratio and allow you to hedge the risk. Our predefined parameters are as follows:
1. The first pair will be AUD/JPY. Annual volatility from May 2002 is approximately 0.2, carry value 4.25%;
2. Second pair let’s will be EUR/CHF. Annual volatility for same period is 0.08, carry value 1.00%:
3. Correlation is 0.384.
Now, we have to combine them so, to get maximum Carry/volatility ratio. For example, if you will use just AUD/JPY pair we will get 0.0425/0.2~0.213.
Our total return on currency portfolio will be: AUD/JPY lot* Carry + EUR/CHF lot* Carry.
Our total risk will be: AUD/JPY lot^2*Volatility^2 + EUR/CHF lot ^2*Volatility^2+2*Lot AUD/JPY*Lot EUR/CHF*Correlation*Volatility1*Volatilty2.
So, if we will apply 50/50 we will get 2.62 annual carry and 0.122 Volatility of portfolio, so risk/volatility ratio will be 0.216.
To calculate optimal weights of both currencies – you have to apply solution search tool in Excel. It will try all possible weights and choose optimal – that will lead to highest return/volatility ratio. This is 0.616 lot of AUD/JPY and 0.384 lot of EUR/CHF. In this case our carry will be 3% annually and volatility just 0.138. Hence risk/volatility ratio is 0.217 – the highest among all possible combinations:
Return = 0.616*0.0425+0.384*0.01 = 0.03 or 3% annually
Risk = (0.616^2*0.2^2+0.384^2*0.08^2+2*0.616*0.384*0.2*0.08*0.397)^0.5 = 0.138.
Hence Return/Risk = 0.03/0.138 = 0.217.
Commander in Pips: Of course. This application is not for replacing of trading and technical analysis. Mostly it could be used for portfolio investors to reduce currency risk if they apply carry trade in their investing framework. This is obvious that this is just an additional tool. It should be applied in line with overall fundamental analysis that we’ve discussed in the carry chapter.
Also it’s worthy to be said here that we used just 2 currencies and correlation is rather solid. If you will find lower correlated pairs and acceptable balance of carries, maybe by using some exotic pairs, – this could give you greater opportunities.
Pipruit: I see.