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Learn to Use the Correlation Coefficient Trading Indicator

INTRODUCTION

The correlation coefficient measures the degree to which 2 instruments’ movements are related. A correlation of -1.0 means perfect negative correlation, and 1.0 is perfect positive correlation. When 2 instruments’ movements mirror each other, they are positively correlated. When 2 instruments move in the opposite direction to each other, they are negatively correlated.

This statistic is useful in various ways. For example, it is used to diversify a portfolio; if all the stocks, mutual funds or ETFs have high positive correlation, the portfolio is hardly diversified. By adding a negatively correlated asset to the mix, diversification benefits are realized.

In currency trading, taking positions in 2 instruments that are highly correlated will have a positive affect if the direction is correct and a negative affect if the direction is incorrect. By having positions in 2 instruments that are not so highly correlated, the two together will moderate both gains and losses.

The calculation is as follows:

If avgV1 = average price of instrument1 for the period, avgV1Sq = average of V1*V1 for the period, avgV1V2 = average price of V1*V2 for the period, var1 = avgV1Sq – avgV1 * avgV1, covar = avgV1V2 – avgV1 * avgV2; Then: CC = covar / SquareRoot (var1 * var2).

Learn How to Use this trading Indicator using real chart examples HERE >>>>