Video Transcript:
There is one very common problem that hurts many traders, even those who have a good strategy. The problem is that there is a hidden risk caused by correlated trades. You may think that you are taking several different trades, but in reality, you may be making the same bet several times. Then, if the market moves against you, all those trades can lose together and damage your equity very, very quickly. The worst part is that many traders do not even realize that this is happening. So, in this video, I will show you how correlation works, how to spot it, and how to reduce your risk when several correlated trades appear at the same time. Let’s get to it.
There is something called positive correlation, and there is also negative correlation. Let’s start with positive correlation. It does not happen all the time, but at certain times, some markets correlate quite heavily, which means that they move in the same direction. If you compare these two charts, which are AUD/USD and NZD/USD, you can see that they correlate quite heavily in certain areas of the chart.
Let me mark those areas. At first sight, it is this zone and this zone—the sell-off on both instruments. There was also heavy correlation here, where there was a rotation, and then the sell-off. Before that, there was this selling activity and this selling activity. It was bigger on NZD/USD, but the two pairs were still correlating. Then there was this zone, which is also visible on both pairs, followed by this rotation, this uptrend, and so on.
All right, so this is positive correlation. It does not happen all the time. As you can see, for example, the markets did not correlate too much here, but there are still signs of positive correlation.
Now, the reason I am talking about this is that you should imagine being in a trade. Imagine you are in a long trade. Imagine there is support on AUD/USD here, and imagine you also have support on NZD/USD here. You enter a long trade from here and, at the same time, another long trade from here.
You are now in two trades that are correlating heavily. If you take a stop loss on both trades because the price shoots past those levels, you are taking double damage, even though those trades are more or less identical. If you take trades like this, they can cause a stronger drawdown.
Now, let me show you what negative correlation is. It is basically the same as positive correlation, only reversed. There are certain instruments that correlate negatively. Very often, it is EUR/USD and USD/CHF. They frequently move in opposite directions.
For example, look at this zone and this zone. EUR/USD was moving downwards, while USD/CHF was moving upwards. This is negative correlation. If the markets correlate like this and you happen to be in a long trade on EUR/USD and, at the same time, a short trade on USD/CHF, the market can move against you in both cases, and you are again taking double damage. Do you see how risky this is?
Now, what about triple damage? This is where it gets really serious and dangerous. Here, we have three markets. Imagine a trade in which we are long GBP/USD, long AUD/USD, and short USD/CAD while this selling and buying activity is taking place at the same time.
If you take these three trades, you are taking triple damage. With trades like these, a drawdown can happen very quickly. That is why you need to reduce the damage—in other words, reduce your exposure to risk.
What you do when you see something like this happening is lower your trading volume. I reduce it to 50%. If three trades are likely to be triggered at the same time and the markets are clearly correlating, I only use 50% positions. If I normally risk 2% per trade, I will now risk only 1% of my equity per trade.
Keep in mind that this requires quick thinking. You need to detect that there is correlated movement, which is very often driven by one currency. In this case, the move is clearly driven by a strengthening US dollar. The US dollar was strengthening here, here as well, and here too.
If you are trading like this and you see one currency strengthening or weakening across the board while you also have trading levels that you would like to trade, you should reduce your risk. It is very likely that all those trades—in this example, all three trades—will have the same result. All of them are likely to be winners, or all of them could be losers. This is how you can prevent large drawdowns and reduce your risk.
Now, I will give you a little more information about correlation so that you know what to look for in your trading. Correlation changes over time and is different on different time frames. Strong correlation very often occurs during macro news and important events that affect one currency.
For example, during macro news, what usually happens is that one currency strengthens or weakens. This causes all the pairs in which that currency is present to move up or down. Everything is driven by that one currency affected by the macro news. This is when strong correlation occurs very often.
There are also some trading instruments and Forex pairs that typically correlate heavily even when there is no macro news. In the picture below, I selected some of the most traded instruments, and the table shows the correlation between them.
Now, let me show you the most important ones—the instruments that have the strongest negative or positive correlations. One example is EUR/USD and USD/CHF. You read it like this. This field shows the correlation between EUR/USD and USD/CHF. This is the correlation on the daily chart, by the way, and it says -94, which means that, at this time, those two pairs have a very strong negative correlation.
Correlation ranges from -100 to +100. A reading of -94 is almost -100. It is very close to it, which means that the negative correlation is very strong.
Another pair of instruments that correlates quite heavily, and not only during macro news, is XAU/USD and USD/JPY. Here is XAU/USD, here is USD/JPY, and there is a very strong negative correlation between them.
Imagine a scenario in which you are long XAU/USD and short USD/JPY. Those trades will most likely correlate, and both trades are likely to be either winners or losers. This creates significant risk exposure.
Let me give you one more example. It is AUD/USD and USD/CAD. These two also correlate heavily, with a correlation of -76% at the time I took this screenshot. As I was saying, correlation changes over time, but at that time, it looked like this. Sometimes, the correlation is even stronger, and it does not only happen during macro news.
It is worth keeping this in mind when you are trading these instruments. If you want to check this table and some additional tools, go to this page. I will leave a link below this video so that you can simply click it and visit the page.
It looks like this. It says that if correlation is above 80%, it is positive, and the currencies move in the same direction. If it is below 60%, the currencies do not move in the same way. Here is the table. You can adjust it here, and here you can find the instruments you are interested in.
This is where you can change the time frame because, as I was saying, correlation changes over time. However, it does not change too much, especially when you use higher time frames such as the daily time frame.
All right, that is everything about correlation and the risks that correlated trades can create.
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