How to Deal with Correlations in the Market

Rayner: In today’s episode, I have a question from Zac, who asked, "Hey Rayner, how do you manage correlations in your trading?" So, before I talk about how I do it, I want to share with you two things about correlations that most traders don't quite get.
[00:00:30] Number one is this, correlations are always changing. If you look back in time, in the '08, '09 financial crisis, you will see that the stock markets are declining, going down, right? And if you look at the bond markets, it's actually going up. Because money is taken out of the stock markets, into the bond markets as a safe haven. So, that is why you have this negative correlation between the bonds and the stock markets.
But if you look at, let's say, recent times, you would notice that both the stock and bond markets are actually moving up in tandem. You can see that the correlation has changed over the last few years.
[00:01:00] So, that's the first point that I want to bring across, is that number one, correlations, they change over time. So what is correlated in the past, does not mean that the correlation will hold in the future, okay?
And number two is this, is that correlations can change depending on the timeframe you're looking at. Let's say, for example, you trade the FX markets, you know the Eurodollar, and pound dollar, and they appear to be correlated on a daily timeframe. But if you go down to, let's say, the lower timeframe, you might see that hey, they're actually negatively correlated.
[00:01:30] So, the second thing that I want to point out is that correlations also depend on the timeframe you're looking at. So that's two things that I want to bring across. So now to share with you, how do you manage correlations in a market? Let me share with you a few things that you can use. The first thing is, you can divide your risk accordingly.
[00:02:00] So, for example, let's say you are bullish on the Euro. You are thinking about buying either Euro Aussie or Euro New Zealand and you can't decide. What you can do is split your risk across this two currency pairs. For example, if you usually risk like 2% on each trade. Now what you can do is risk 1% on Euro Aussie and 1% on Euro New Zealand. Right? That's the first thing you can do. Split the risk.
[00:02:30] The second thing you can do is to, what I call, pick the strongest market to long and short the weakest market. So if for example, Euro Aussie and Euro New Zealand, you realize that Euro Aussie is a stronger currency to long compared to New Zealand, maybe because the moving rate is steeper or maybe because Euro Aussie is the first market that breaks out.
What you can do is, long the strongest and ignore the second tier currency pair. That's another way you can go about it.
[00:03:00] And the final thing to share is understanding the markets you're trading. For example, which markets are correlated, which are not correlated, how strong the correlation, how weak their correlation and stuff like that. It's really based on understanding the markets, watching the markets, and then knowing which are the different correlations out there because it's always changing as I've shared with you earlier. Understanding the markets would definitely help you as a trader, dealing with correlations.
And so, that's pretty much it for this week's question. If you have anything that you want me to answer, just let me know in the comments section below, all right, and I'll get back to you. With that said, head down to my website, tradingwithrayner.com where you'll learn trading strategies that work right so that you can get rich slow.
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