Trading Indicator Toolbox – Correlation Coefficient

Trading Indicator ToolBox

The original Analysis Toolbox articles discussed the various market cycles including trends and continuations. This part of the The Trader’s Indicator Series focuses on the Trading Indicator Toolbox, as we will discuss various indicators that are found on most trading platforms. We will discuss the indicator in the context of the chosen market, and if it resonates with you, please continue to do your own analysis with it. Trading successfully is all about feeling comfortable with a methodology and using that system repeatedly even when boredom sets in. I will be discussing indicators in alphabetical order that can be found on the MotiveWave platform. (for a free 2-week trial CLICK HERE)

The Correlation Coefficient is a measure of the price relationship between 2 instruments. The CC is positive when the instruments prices move in the same direction, negative when they more in opposite directions. The range is -1 to +1.

Correlation Coefficient Trading Indicator

image of correlation coefficient trading indicator on trading chartimage of trading chart for S&P vs Nasdaq with correlation coefficient trading indicator

 

 

 

 

 

 

INTRODUCTION

The correlation coefficient measures the degree to which 2 instruments’ movements are related. A correlation of -1.0 means perfect negative correlation, and 1.0 is perfect positive correlation. When 2 instruments’ movements mirror each other, they are positively correlated. When 2 instruments move in the opposite direction to each other, they are negatively correlated.

This statistic is useful in various ways. For example, it is used to diversify a portfolio; if all the stocks, mutual funds or ETFs have high positive correlation, the portfolio is hardly diversified. By adding a negatively correlated asset to the mix, diversification benefits are realized.

In currency trading, taking positions in 2 instruments that are highly correlated will have a positive affect if the direction is correct and a negative affect if the direction is incorrect. By having positions in 2 instruments that are not so highly correlated, the two together will moderate both gains and losses.

The calculation is as follows:

If avgV1 = average price of instrument1 for the period, avgV1Sq = average of V1*V1 for the period, avgV1V2 = average price of V1*V2 for the period, var1 = avgV1Sq – avgV1 * avgV1, covar = avgV1V2 – avgV1 * avgV2; Then: CC = covar / SquareRoot (var1 * var2).

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Jody
Jody Samuels, a former institutional trader for a US Investment Bank, and author of The Trader’s Pendulum, The 10 Habits of Highly Successful Traders, founded FX Trader’s EDGE in 2006. A premiere, global online Trading and Coaching School, FX Trader’s EDGE is home to the Forex Foundation and Elliott Wave Ultimate, progressive educational training programs to assist traders of all levels in the markets. FX Trader’s EDGE offers individual and institutional clients proprietary tools, services and education to trade Forex, CFD’s and Stocks online. One-on-one coaching is also available.
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Jody

Jody

Jody Samuels, a former institutional trader for a US Investment Bank, and author of The Trader’s Pendulum, The 10 Habits of Highly Successful Traders, founded FX Trader’s EDGE in 2006. A premiere, global online Trading and Coaching School, FX Trader’s EDGE is home to the Forex Foundation and Elliott Wave Ultimate, progressive educational training programs to assist traders of all levels in the markets. FX Trader’s EDGE offers individual and institutional clients proprietary tools, services and education to trade Forex, CFD’s and Stocks online. One-on-one coaching is also available.

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