How to Trade a Correlation Strategy

10/30/2009 12:01 pm EST

Focus: FOREX

 

While correlations will tell you that a move is about to occur, correlation alone doesn't tell you which pair is moving or the direction it will be moving in. In other words, you know you need to put on a trade, but you don't know which pair to trade or whether you need to buy or sell short. This massive limitation in correlation trading has stifled traders for years, which is why so few traders use correlations despite the obvious benefits.

Of the handful of traders who do trade with correlations, most just use it as a filter to increase the accuracy of an already profitable system.  I decided to take it further and made it my main trading strategy.

As a full-time trader, researcher, and system developer, I know that identifying predictable volatility is half the battle. Determining entry and exit points is simply a matter of testing and a whole lot of trial and error. It took the better part of 12 months, but eventually, I researched, developed, and tested 82 different strategies for capitalizing on correlation trades. When the dust settled, we were left with only eight that made the cut. Here's one that did.

Follow the Leader

The strategy is called "Follow the Leader," and while it's one of the simplest of the eight strategies I learned, it's no less important.  The "Follow the Leader" correlation trade, like all correlation trades, waits until two correlated pairs go "out of whack" and then quickly capitalizes on the opportunity to scalp some quick pips out of the market.

Here's how it works:

For this system, I like to trade the EUR/USD along with the GBP/USD. These pairs are positively correlated, so as expected, they are more or less moving parallel to one another (as seen on chart below). But when we're trading with correlation, we're not only looking at direction, we're also looking at the range.

Range is of course the difference between the high and the low prices during a specified period of time. We know, for example, that the GBP/USD normally has a much larger range than the EUR/USD.  In other words, while these correlated pairs will generally move in the same direction, the GBP/USD should have lower valleys and higher peaks than the EUR/USD. So, when we see that the range of the GBP/USD is lagging behind the range of the EUR/USD for one bar (see chart), we have a potential trade setup.

Once the "range lag" is 20 pips or greater, we take the trade with the expectation that the GBP/USD will make up the gap and overtake the range of the EUR/USD within a few bars. I know this is an extremely high probability trade because "Fundamental Law" dictates that the pairs must remain in correlation, so therefore we know that they will eventually snap back.  It is a strategy that has been backed by market fundamentals and testing for years, and I've also found it to be one of the most accurate (and profitable) intraday strategies I've ever traded.

OK, let's check out the chart as mentioned above:


Click to Enlarge

Right now, the range of the GBP/USD is lagging the EUR/USD by eight pips. That's enough of a lag to take notice, but it's not enough to take the trade yet. I like to see at least a 20-pip lag before I take the trade, so I'll watch it for another bar and see what happens.

MORE: Continue Reading on Page 2

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Click to Enlarge

When the second bar closes, the range is now lagging by 15 pips. It's still not enough for me to take the trade yet, but the fact that the range lag still hasn't corrected itself (and is actually growing wider) has me very excited.

I'll wait and watch it for one more bar and see if the "range lag," or "crack," widens enough for me to take the trade.


Click to Enlarge

The third bar has closed, and the "range lag" has now widened to 24 pips. That's greater than the 20-pip minimum I need, so I'm going to take this trade and go long on the GBP/USD.

My expectation is that the GBP/USD will at a bare minimum make up the 24-pip "range lag," or "crack," and possibly even go beyond that since historically, the range of the GBP/USD is supposed to be larger than the EUR/USD. When we're trading with correlation and something goes "wrong" (as is the case with this "range lag"), that usually means there's a profit opportunity just around the corner.

Now that we're in this trade, let's watch it and see what happens next.


Click to Enlarge

As you can see, the very next bar, the GBP/USD made up the "range lag" and returned to "normal" just as we expected it to. We then exit the trade at the end of the bar and pocket the 24 pips.

That is the "Follow the Leader" strategy!

So to recap, you need to:

1) Watch these two pairs simultaneously
2) Track the movement of both pairs at the close of each bar
3) Once you see one of the pairs begin to pull away, pay attention because you are now looking at a potential trade setup
4) Calculate the "range lag," or "crack," and when it exceeds 20 pips, you're ready to pull the trigger and you know what your target will be, as it will be always be about equal to the "range lag"

I'm confident that this one strategy alone will make you a more confident, accurate, and profitable trader.

By Jason Fielder
Jason Fielder is a full-time trader and blogger at Correlation Code.

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