*Why and how to trade simple divergence in correlated markets*
In this blog post I am going to share with you a different method of trading positive correlations in the financial markets. Before I start, if you haven’t read my previous blog post explaining the main market correlations I trade and why they exist, please click on the link below.
For the purposes of this blog post and strategy explanation, I will use the Spot Gold & Australian Dollar FX currency pair price charts which tend to show a positive correlation over the longer term. This is clearly visible on the higher timeframe charts where price movements tend to follow a similar pattern on both instruments.
The chart above shows pricing for a 10 year period from April 2006 to March 2016 and as you can see, the 2 financial instruments move in a similar direction over time. When the value of Gold (blue) is increasing, so is the Australian Dollar (black line).
This is positive correlation. Correlation can be measured on a scale from -1.0 through +1.0 with perfect negative correlation being -1.0 and perfect positive correlation being +1.0. The most common formula used for calculating the correlation coefficient of two data sets is the Pearson R formula.
Using 4 price points of reference between October 2008 and May 2011, Spot Gold and AUDUSD had a correlation coefficient of +0.9547. During this time Spot Gold increased in value by 116% and AUDUSD increased by 228%.
This is an extremely high positive correlation.
What is correlation divergence?
Naturally over time, the correlation coefficient of two financial instruments can increase or decrease depending on external factors influencing the price of each individually. I use the term correlation divergence to describe the point when the correlation coefficient switches and becomes negative as opposed to positive (or the opposite for a normally negatively correlated pair of financial instruments).
This more commonly occurs on the lower timeframes where you can see big swings in correlation coefficient because of the influence of economic data, supply levels (for Gold) and general speculation on each instrument.
The chart below shows Spot Gold and AUDUSD but on a much shorter timeframe of only 4 months.
Just by using your eyeballs you can see that the normal (long term) positive correlation is no longer in existence. This is indicated by the price of gold increasing, the price of AUDUSD decreasing and the crossover of the 2 prices on the chart.
During the period from 8th July 2019 – 3rd September 2019, using the exact same methods of calculation, the correlation coefficient of Spot Gold and AUDUSD was -0.6795.
The long term positively correlated instruments are now operating as if they are negatively correlated. This presents a trade opportunity.
If the long term correlation of these two instruments is naturally positive, it is safe to assume that this will continue and therefore at strong levels of negative correlation there is likely to be a reversal.
The idea is then to place two trade positions in opposite directions, one on each financial instrument, and trade the play that suggests the divergence between the prices of these two instruments will begin to reduce. They will then go on to begin acting positively correlated again and the correlation coefficient will go back above 0.0 once again.
The chart below shows this effect happening.
By buying the instrument dropping in price and selling the instrument that has been increasing in price, you can trade the price gap reduction.
The benefit of the “hedge” having both positions open is that you profit from both Gold reverting back to its normal positive correlation (and shorting it) and AUDUSD reverting back to its normal positive correlation (and going long).
Another benefit is that you can choose to trade the divergence that benefits you. Buy shorting Spot Gold and going long on AUDUSD you benefit from net positive carry across the 2 instruments. This allows you to hold the hedge positions for as long as possible and gain a long term profit from the carry fees paid to you.
The chart above shows the 4 month period after the hedge trade would have been executed. As you can see, the price difference reduces and the two financial instruments start to become more positively correlated and begin to move in the same directions again.
From 1st November 2019 – 31st December 2019, Spot Gold and AUDUSD had a correlation coefficient of +0.907. Back to a strong positive correlation.
This is fairly “advanced” trading and it is not without its risks. Position sizing and risk management is key to the long term success of trading like this. Over exposure can cause problems if the divergence does not begin to reduce quickly.
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DISCLAIMER: None of the information posted on this site is to be considered investment/financial advice. Trading is high risk and you should only trade with money you can afford to lose.