Tips for Trading Correlated Markets

09/14/2011 3:30 pm EST

Focus: STRATEGIES

Toni Hansen

President and CEO, Trading From Main Street

Markets that are highly correlated often present great trading opportunities, and trader Toni Hansen uses the commodity and currency markets to illustrate key factors to watch.

Correlated markets, or markets that tend to move together, can offer some great trading opportunities. Our guest today, Toni Hansen, is here to talk about that. So Toni, what correlated markets do you like to trade?

Well, what’s been really popular lately is the commodity and currency pairs. We see a lot of situations where a lot of these currency pairs will be really tightly correlated to things like oil and gold, in particular. 

So when you are looking at commodity and currency pairs and how they correlate, some of the big ones to watch would be the Australian dollar and the Canadian dollar.

Australia, of course, is very tied to gold, and the New Zealand dollar is very closely tied to the Australian dollar, so you often see both of those have a strong correlation to what is going on in the gold market because Australia is one of the top producers in gold. 

Alternately, we have the Canadian dollar, which is another one of those where we see a lot of correlation to the commodities; in this case, it is oil because [Canada] is one of the top places where you will find oil. They believe it is the second-largest reserve behind Saudi Arabia. It tends to be ninth and tenth in terms of oil production and exporting. 

So a lot of times, you will see really strong correlations between these, but when looking at trading them, you have to look for the divergences—when you are starting to see one of them begin to lead and one of them begin to lag.

Sometimes you will have the Australian dollar leading gold slightly, and that can last for a number of months, but then they will start to come into alignment and then it will begin to lag.

So you can use these periods where it is being a leader to kind of develop a strategy for what is going to happen in gold and follow that.

A lot of times, I will look for reversal patterns in one of the particular ones, such as the leading security. When I have that reversal pattern, oftentimes you will find that you will then get the reversal following in the lagging one. So if you miss a strong signal in one of them, you have a chance to pick it up in the other one. 

There are also times where you will have them correlating, but one of them will be stronger than the other. So both of them might be heading lower, but one of them forms a stronger reversal pattern than the other, and as they do so, sometimes the one that is slower can actually gain momentum stronger than the one that starts heading up higher first. 

It kind of gets flushed out a little bit more, you could say. So when it is slower and taking more time and kind of just ticking lower and lower, a lot of times even though the other one had turned higher, the one that was ticking lower will have the stronger reversal. That offers a really good trading opportunity. So those are some of the things that I look for.

If you can catch it early enough, would you suggest shorting one and going long the other until they come back together?

Usually I don’t because it can be unpredictable how long those divergences are going to last. Sometimes they can last a couple days; sometimes they can last a couple weeks. We’ve seen a little bit more decoupling over the last couple weeks, for example, and you don’t want to be too aggressive in terms of the hedging because a lot of times I find that one will just go flat.

I’m not too much of a hedger, so I like to be in the one that I think has the strongest possibility. If you are into hedging, that’s something you could look at, but personally, it’s not something that I do.

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