Use Correlation between Asset Classes to improve your trading
It’s accepted that those who diversify their portfolios tend to see better returns than those who “put all their eggs in one basket”.
In the same way, traders who only analyse a single market will struggle against those who look at several markets/assets at once.
Because, by following several markets, you’ll be able to see how they are related to each other, and thus spot changes in the market before other, more narrowly focused traders will be able to.
Broadening your trading outlook will allow you to spot more profitable and reliable trading opportunities, as well as more chances to better protect your investments.
This method, otherwise known as Intermarket analysis allows you to fine-tune your trading approach by understanding the existing relationships between the different asset classes.
By analysing commodities, currency pairs, bonds, shares, and indices within the same time period, you get a better idea of the tendencies of a particular asset thanks to the movement of other correlated assets.
Remember, neither asset classes nor markets move in isolation.
Using the most popular MT4 trading platform, you can take advantage of the technical analysis, market commentaries and market news updates to see how the different markets and trading instruments move in tandem or in different directions.
By monitoring the movements of different assets on a daily basis, you will get a better feel and appreciation of which assets are highly correlated or not.
Two highly correlated assets that move in the same direction and at the same time are said to be “positively correlated”.
Conversely, when two assets evolve in opposite directions, they are considered to be “negatively correlated”.
When two assets aren’t correlated at all, it means that there is no systematic or linear relationship between their returns.
A correlation coefficient can be between -1 (strongly negatively correlated) and 1 (strongly positively correlated).
When the coefficient is at or close to 0, then the assets have little to no relationship; they’re more or less independent.
The Forex market is often linked to monetary policy decisions, which strongly affect the bond market, which is reflected in higher or lower bonds yields, as well as bond spread.
The FX market and the bond market are therefore positively correlated and highly dependent on interest rate decisions from central banks.
Example of correlations between markets
Let’s take the example of the US dollar and the 10-year Treasury note.
When investors expect the US Federal Reserve to tighten its monetary policy and increase interest rates, the US dollar usually strengthens against other currency pairs.
The yield of the 10-year Treasury note also increases, which tends to negatively impact the stock market due to higher inflationary pressures, which can alter the purchasing power of the US dollar.
This has the knock-on effect of affecting U.S. exports as US-based products are rendered more expensive abroad.
Let’s have a look at another relationship with the US dollar.
Many commodities are priced in USD, which means that any upward or downward movement in the US dollar will affect the price of these commodities, meaning they have an inverse relationship.
The commodities that have the strongest correlation with the US dollar are Oil, Gold, Copper, and soft commodities such as wheat.
Let’s look at another example – Australia is a large exporter of precious metals, such as silver and gold.
Therefore, the correlations to focus on here are between the AUD/USD currency pair and the price of silver and gold.
Gold is also mined in New Zealand, so Gold also correlates with the NZ dollar, but to a lesser extent than the Aussie dollar.
Canada is a large oil producer, so any movement in the USD/CAD currency pair will affect the price of Oil, and by extension its consumption.
On the other hand, more fundamental factors negatively affecting the consumption of oil will alter the attractiveness of the CAD to foreign investors, as the country’s economy is strongly dependant on oil exports.
What to be careful while using correlation of markets
Remember that correlation is a useful metric that provides important information for a trader to better diversify their portfolio, and therefore mitigate its risks.
Correlation can be used to minimise risk while maximising returns.
However, it’s important to remember that relationships between different asset classes or trading instruments evolve depending on particular circumstances (economic conditions, market regimes, etc.) and that they are not systematic.
Do not solely rely on correlation, but combine it with other qualitative and quantitative information, as well as common sense and objective judgment.
Importance of support and resistance when trading FX
One of the most frequently mentioned words in Forex trading is support and resistance.
This is because they are important levels that give signals on the next price moves.
Whether you’re trading forex, CFDs or commodities, it is important to know where support and resistance sit.
Looking for support and resistance levels
Support and resistance levels can be tricky to view on a chart when starting out, but over time, they become second nature.
After viewing a few charts, you will be able to spot support and resistance levels with ease.
Let’s look at two charts highlighting these key levels.
In this chart, you can see that price has bounced back for several times when it hit the support level.
This means traders are supporting the price move at this level and not letting it go lower.
This is when a support level is established. If this level is tested several times, it is more likely to hold.
On the other hand, this chart shows the resistance level.
This means traders are not pushing this price any higher than this level, that’s why it is called resistance.
It means any attempt to try to go higher is being met with strong resistance.
Why is support and resistance important for your trading?
It is important to know where support and resistance levels are because they signal trader sentiment.
If traders are bullish and able to break through a resistance level, prices will escalate quickly.
However, despite some bullish sentiment at times, traders are also wary when prices go near the resistance level because it could mean prices will be rejected and go lower.
On the flip side, if traders are bearish, a break of a key support level will trigger a number of stops and see the price fall quickly.
Psychology behind support and resistance
From a technical analysis point of view, support and resistance levels tell a lot about traders’ psychology.
Here are three most common interpretations of support and resistance levels.
- Length of time or frequency
the longer a price stays on a certain support or resistance level, the more important and stronger that level gets.
For example, in the chart below, the Aussie dollar was trading on a tight range between .75 – .77 cents.
And whenever the price moved to .77 cents or just above it the sellers stepped in and drove the price lower.
This price action went on for several months, indicating that.77 cents was a key resistance level for the Aussie dollar.
From the trading psychology’s point of view, this means traders are willing to support the Aussie dollar but only up to a certain level – in this case at .77 cents.
Anything over 0.77 and traders felt the Aussie Dollar was overvalued and expensive.
- Trading volume at key levels
heavy trading volume at a support or resistance level will indicate the importance of that level.
Many technical traders use the combination of volume and support and resistance levels as indicators or signposts.
For example, if there’s heavy trading volume on a support level, this could mean the bullish traders are willing to buy at that price.
On the other hand, there must be the bearish traders on the other side trying to pull the price down.
- Switching of roles
while support and resistance levels can be solid and defined at times, there are also instances they will swap roles.
This will happen when a previous support level is breached. Once breached, prices often attempt to rally back to the previous support, turning it into a new resistance level.
The same is true with a resistance level that has been breached and then turns into a new support level.
Both of these scenarios mean trader sentiment has reversed. As a trader it is best you take note of the change in sentiment as it could drive the next direction in price.
3 Best Ways to Capture Long-Term Trends in Forex Trading
Most beginner traders in the Forex market tend to choose to trade with short-term strategies because of the perceived rewards of instant gratification.
While there is no doubt short-term trading strategies can work well when trading forex, long-term strategies can also be as profitable, if not more so (than short-term strategies).
The idea behind long-term approaches is to make fewer trading transactions with larger gains based on a trend following strategy – often called positional trading.
So, let’s consider the three best ways to capture long-term trends in forex trading.
#1: Know what a trend is
Before opening a position, you better make sure you know where you are within the main trend, so you do not trade against it.
As described in Dow Theory, markets move in a general direction (up or down) but not in a straight line, as they will form peaks and troughs.
A bullish trend is formed with higher peaks and higher lows, while a bearish trend is formed with lower troughs and lower peaks.
When none of the buyers or the sellers are in control, you can often see a consolidation phase, where prices drift in a range.
The best way to identify a trend is to look at chart patterns that will show the price movement of a currency or any trading instrument.
By looking at charts, you will have a more graphical view of the price movement – whether they are moving up, down or sideways.
#2. Identify the prevailing trend
Dow Theory also explains there are three kinds of trends: a primary, a secondary, and a minor one.
To find the primary trend, you need to look for a large movement lasting between 1 and three years.
This trend is valid until there is a confirmed reversal signal.The secondary trend is usually the one that is a corrective movement against the main trend.
It’s an intermediate trend lasting from 3 weeks to 3 months.
The minor trend usually lasts less than three weeks and is often a corrective movement within the secondary trend. Once you have identified the prevailing trend, then you can adjust your trading strategy accordingly.
As the market saying goes ‘the trend is your friend’ which means you will be better off trading with the trend instead of against it.
Trading with the trend tends to be more profitable as it will allow you to capture the big moves whether in the forex, equities or commodities markets.
#3. Know what factors drive currencies in the long-term
Central bank decisions are among the most influential factors in the global forex market.
A central bank is the monetary authority of a country that makes decisions about interest rates, inflation levels and other policies that affect the flow of money in a country.
These often revolve around achieving price stability and a strong job market to stimulate economic growth.
Any figures that are released on inflation, employment, consumer/business confidence, and growth are important to follow, as they can trigger volatility on currency pairs.
This volatility is linked to changes in traders’ forecasts regarding the path of a given monetary policy depending on the available data.
A central bank can either decide to tighten monetary policy or loosen it.
Tightening will usually push a currency higher, while loosening will push it downward.
This is the reason why most traders keep an eye on the regular central bank decisions such as those from the US Federal Open Market Committee (US FMOC), European Central Bank (ECB), Bank of England (BOE), Bank of Japan (BOJ), Reserve Bank of Australia (RBA) and Bank of Canada (BOC).
Nowadays, central banks communicate quite clearly about the way they see the monetary policy in the future, so then investors aren’t surprised when things happen, and volatility is under control.
Best practices to define the long term trend
Traders should focus more on finding the primary and the secondary trends, as market noise tends to affect the minor trends much more.
Trend trading requires finding the trend first, then managing entry and exit points using previous highs and lows to trade breakouts.
To enhance your positional trading strategies, you can follow some general guidelines including:
- Always remember how to identify a trend by looking at highs and lows
- Once you know the underlying trend, work on your entry points with relevant money management tools
- Use small leverage and pay attention to swaps – these are the fees you will pay or receive for holding a position overnight
- Stick to your trading plan and control your emotions
- Know how to use trailing stop losses within your exit strategy