Advanced risk management
Correlations and risk management
Financial markets rarely move entirely in isolation. A trend in one asset will often ripple around several others, meaning some prices rise and others fall.
This effect is called market correlation. While it can be useful for spotting opportunities, it can also increase your risk if you aren’t careful. But by understanding how correlation works, you can take a significant step towards lowering your overall risk.
What is market correlation?
Market correlation is a measure of how much assets move in line with each other. You can measure the correlation of specific markets, industries or entire asset classes.
Correlation is usually measured as a percentage. If two markets are 100% correlated, then their movements will always be the same. When one rises, so will the other. This is called a perfect correlation.
The FTSE 100 and a FTSE 100 CFD should have a 100% correlation, for example, because a FTSE CFD will always mimic the price movements of its underlying market.
A 50% correlation, meanwhile, means that the two markets generally move in the same direction but may not always follow each other in lockstep.
Stocks in the same sector may show very high correlation rates, which can make it difficult to find a share that outperforms its peers. Forex pairs are also often highly correlated – especially when they feature the US dollar.
Types of correlations
There are three types of correlation:
- Positive correlation describes markets that mimic each other's movements
- Negative correlation describes markets with inverse movements
- No correlation describes markets with no relation whatsoever
-60% to -100%
-20% to -60%
-20% to 20%
20% to 60%
60% to 100%
Strongly negatively correlated
Slightly negatively correlated
Why correlations are important
Correlations can have a significant impact on your overall risk level and your bottom line, chiefly because they act against diversification – and can mean that one market moving against you impacts your entire portfolio.
For example, if you have open short positions on two markets with a 75% positive correlation, then it is probable that a bear trend in one will lead to the same move in the other.
In this case, you risk losing the capital allocated to both positions if one moves against you. So your total risk from the trade could be higher than you originally planned.
If you have multiple correlated positions, then your overall risk on a portfolio level could be far higher than you think. So it's always worth researching which markets are related, and which can add to your diversification.
Profiting from correlations
You can also use correlations to target profits. One stock trading strategy, for example, involves finding correlated companies and monitoring their price action. If one stock diverges from the rest, you can take a position on its eventual return to the norm.
Volatility can have an impact on correlations. In times of high volatility, markets tend to become more correlated – which may increase your overall risk.
A few key market correlations
Some correlations are only temporary, others have lasted for years and look set to continue. Here are some common examples to be aware of in your trading.
1. USD and gold
Perhaps the best known correlation of all is between the US dollar and gold. Gold is priced in US dollars, so its price is hugely dependent on the strength of the currency. When USD rises, gold’s price will often fall – a strong negative correlation.
2. AUD/USD and copper
Lots of currency pairs are closely correlated to commodities. This usually occurs when an economy is dependent on commodities to grow. Australia, for instance, derives a large portion of its wealth from metals mining. So the price of AUD/USD can move as copper prices move.
3. USD/NOK and Brent crude
USD/NOK, on the other hand, has an inverse correlation with the price of Brent crude. Why? Because Norway is one of the top exporters of Brent, which accounted for some 18% of its GDP in 2018.
4. Stocks and commodities
If a company is dependent on a particular commodity for its operations, then its share price is highly likely to be correlated with it. Airlines, for example, are huge consumers of oil. When oil’s price is high, they may suffer, which plays out on the markets.
Miners, on the other hand, will make more profits when metal prices are high. Some traders use this to get indirect exposure to metals – instead of investing in commodities, they buy mining stocks.
Test your knowledge
- A Move up
- B Move down
- C It’s impossible to say
- A Move up half the time
- B Move down half the time
- C It’s impossible to say