Understanding correlations and performing intermarket analysis can help forex traders spot good opportunities, writes the staff at Investopedia.com.

The relationships between different financial markets are almost as old as the markets themselves. For example, in many cases when benchmark equities rise, bonds fall. Many traders will watch for correlations like this and try to capitalize on the opportunity. The same types of relationships exist in the global foreign exchange market. Take, for instance, the closely-related tie between the Australian dollar and gold. Due mostly to the fact that Australia remains a major producer of the yellow metal, the correlation is an opportunity that not only exists, but is one that traders on every level can capitalize on. Let's take a look at why this relationship exists and how you can use it to produce solid-gold returns.

Being Productive Is Key
The US dollar/crude oil relationship exists for one simple reason: the commodity is priced in dollars. However, the same cannot be said about the Aussie correlation. The gold/Australian dollar relationship stems from production. Australia is one the largest gold producer in the world. As a result, it is only natural that their currency follows a similar pattern to gold. With the ebb and flow of production, the exchange rate will follow supply and demand as money exchanges hands between miner and manufacturer.

Capitalizing on the Relationship
Although the macro strategy does work on all levels, it is best suited for portfolios that are set in longer time frames. Traders are not going to see strong correlations on every single day of trading, much like other broader market dynamics. As a result, it's advantageous to cushion the blow of daily volatility and risk through a longer time horizon.

Fundamentally oriented traders will tend to trade one or both instruments, taking trading cues from the other. These cues can be gathered from a list of topics including:

1. Commodity Reserve Reports
2. COT Futures Reports
3. Australian Economic Developments
4. Interest Rates
5. Safe Haven Investing

As a result, these trades tend to be longer than day-trade considerations as the portfolio is looking to capture the overall market tone, rather than just an intraday pop or drop.

Technically, traders tend to find their cues in technical formations with the hope that corresponding correlations will seep into the related market. Whether the formation is in the gold chart or the Aussie chart, it is better to find one solid formation first, rather than looking for both charts to correlate perfectly. An example of this is clearly seen in the chart examples below.

chart
Figure 1
Source: FX Trek Intellicharts
Click to Enlarge

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Figure 2
Source: MetaTrader
Click to Enlarge

As shown in Figure 2, with the market in turmoil and investor deleveraging that was "en vogue" in 2008, traders saw an opportunity to jump on the bandwagon as both Aussie and gold experienced a temporary uptick in price. Already knowing that this would be a blow-off top in an otherwise bearish market, the savvy technical investor could visibly see both assets moving in sync. As a result, technically speaking, a short opportunity shone through as the commodity approached the $905.50 figure, which corresponded with the pivotal 0.8500 figure in the FX market. The double top in gold all but ensured further depression in the Australian dollar/US dollar currency pair.

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