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Forex 4 Fun: Finding Countertrends with Correlation

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January 1, 2011

Many traders find they are able to spot the top of the market or a bearish trend in equities, but are not willing to pull the trigger on the bearish trade. For one reason or another, most people are wired to look for bullish opportunities, and quite frankly, they can miss the forest for the trees. But what if there were a way to spot bearish opportunities while bullish trends are occurring elsewhere, and vice versa? That's what inverse correlation is all about, and it tends to happen frequently in the forex markets—particularly when comparing price action between equities and the dollar (USD) in recent years.

Where There's a Bull, There's a Bear

In trading geek-speak, correlation has to do with how assets move in relation to one another. In the world of stocks, two companies in the same sector—say, automakers— often tend to be highly correlated (i.e., have positive correlation) and move together. Though, over the long term, the dollar and US equities have been highly correlated, recently, that trend has reversed. In other words, as the dollar has moved lower, stocks have moved higher. When stocks crashed in 2008, for example, the dollar finally broke its multi-year downtrend. When traders started piling in on equities in March of 2009, we saw the dollar take another tumble until the equities peaked in April 2010. Could this mean the dollar/equity relationship is primarily due to traders running to cash at the first sign of fear?

Correlation values vary from -1 to + 1. A negative value indicates a negative or inverse correlation. A positive value is a positive correlation. The calculation simply compares relative price moves between two instruments over a specific time. If they move up together point by point, the value will be 1, or 100% correlated. If they move opposite to each other (one moving up and one moving down point by point), the value would be -1, or 100% inversely correlated.

correlation indicator chart thinkorswim

FIGURE 1: OPPOSITES ATTRACT.

Using the correlation indicator on the thinkorswim® from TD Ameritrade charts, you can start to gauge whether one asset tracks another in its movement, or in the case of the U.S. dollar vs. the S&P 500, they tended to move opposite of one another for most of 2010. For illustrative purposes only. Source: thinkorswim from TD Ameritrade. For illustrative purposes only. 

Based on data between January and early December of last year (see chart in Figure 1), the S&P futures (/ES) was inversely correlated (below the zero line) to the dollar index (/DX) for most of the year. Extreme readings above 0.5 have strong positive correlation and below -0.5 have strong negative correlation, respectively. Readings between 0.50 and -0.50 are relatively weak correlations. However, specific readings at certain points in time aren't as important as the overall trend for a period of time, such as the whole of 2010. How can a trader use this to his or her advantage? The trade might be to buy dollars when equities are falling, and sell dollars and buy equities when they are rising.

If the inverse correlation continues to hold true, buying dollars at resistance levels in equities and exiting dollar-long trades at equity support levels could be one opportunity. And if the U.S. economy does see the dreaded “double-dip” recession after all, what kind of returns might be made on the dollar while others flee the sinking ship of the equity markets? Are equities setting up for that next drop? Time will tell.

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