Important Lesson About Market Correlations

Correlations are awesome, but they won't work perfectly all the time, remember markets don't move in vacuums.
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We’ve had a couple of questions recently regarding movements in certain currencies or pace, or asset classes that don’t necessarily always follow the usual correlations.

Now, a good example of this is when we might have a risk-on tone and high beta currencies are moving down, which is something you won’t expect or when we have risk-off tones, and you see safe havens are losing ground, again, not something you would expect.

Other examples can be when we have strong risk flows, let’s say risk-on, but bond yields are moving lower, or when we have strong moves in oil prices, for example, but we don’t see the same type of reaction in the petro currencies like the CAD. So what can we make of these types of moves? Well, there are a few very important points to make and always keep in mind. Firstly, correlations are very, very helpful, but they’re never perfect, so they don’t always work 100% of the time.

They do certainly work most of the time, which is why we can observe them as correlations, but they won’t work 100% of the time, all the time, day in and day out. If that was the case, trading would of course, be easy. But trading we know is not easy because the market doesn’t move in vacuums, right. There’s always multiple factors involved that we need to keep in mind.

So, don’t expect correlations to work all the time. Sometimes the market just has another idea in mind, and that is why we do things like risk management and make sure not to over leverage on trades. And that way, as long as we play these correlations in the long run, we will of course make money from them.

Secondly, it’s also important to remember that markets don’t move in straight lines.

So for example, when we have a risk-on tone, that doesn’t mean that the Aussie Yen, for example, will just shoot up in a straight line and continue moving higher throughout the whole session. Sometimes that does happen but the more higher probability outcome is that the market will oscillate, so the market moves up, and then pulls back or the market moves down and then pulls back. A pullback doesn’t mean that the trend or the move is suddenly over, a pullback is simply just part of the usual ebbs and flows that we see in the market.

Now even though there’s money to be made with clear sentiment shifts by simply just jumping in and writing it out, it’s in the pullbacks with normal day trading type of trades or swing trades where lots of value can be found. So if a bias for a particular pair is to the upside, and it starts to pull back but nothing is changed, then the pullback is an opportunity to simply buy that on sale. So remember, as traders, we are always looking for value. So we speculate on price moves because we want to profit from them. So when something is on sale, we buy it, so we try to buy it low or sell it high. And that means that we’re not afraid of pullbacks because they can offer some of the best trading opportunities there is.

Now having said that, that doesn’t mean that we are just going to be blind of pullbacks, we always need to keep our finger on the pulse and ask ourselves whether something has changed. So if you’re trading, let’s say the pound versus the US dollar, as our dominant currency seem to be the theme today, if you’re trading that to the upside, and it starts to suddenly pull back, the very first question you need to ask yourself is, has anything changed? So has the reason for entering the trade changed?

Has the market condition suddenly changed? Is there any new fundamental news flow that has crossed the wires that can be affecting the overall market sentiment, all that overall bias? But if nothing has changed, then we can simply stick with our trade with confidence, knowing that the sentiment should play out most of the time. Now, that doesn’t mean that we won’t have losing trades, of course, the market can stay irrational for much longer than we can stay solvent, that is something important to keep in mind. But again, that is why we use things like stop losses.

That is why we do proper risk management, and why we never need to over leverage on trades and why it’s so very important to continuously work on our trading psychology to get rid of that fear that gets us into bad trades, and of course, that fear that gets us out of good trades.

So, that is why having a process in trading is so important. And even more important, is always to stick to that particular process no matter what the conditions are.

Thirdly, uncertainty is really part of the trading game.

The market is rife with uncertainty, every single second of every day. There’s no guarantees in trading. And sometimes the market will just move in a very classic and expected way, and the very next day, it just won’t care about something, right.

So, these uncertainties are part of the game, it really helps to learn who Mr. Market is. So always trying to front run how it will think about things, how it should think about things, how it will feel about things, those type of things will come with experience.

For the more analytical minds like me, this was something that caused a lot of frustration, was that uncertainty, because I always wanted to know why, why, why, why, why is this happening? Why is that happening? And that curiosity is good, because there usually are reasons for the markets to move.

But sometimes, it’s just the market being the market, and we need to be okay with that. And as a trader, we need to let go of the desire to try and control the market, that’s impossible. The only thing that we can control in this game is ourselves. So making sure we understand why we are trading, what we’re trading, why the biases skew to up or to the downside, and making sure we always, always, always follow our process to control our risk exposure, and stop losses to control our leverage.

The rest is really up to us because again, the market can stay irrational for longer than we can stay solvent.

So, learn to embrace the uncertainty, I know it might be more difficult for some like it was for me, especially, I’m one of the more analytical brains out there. But not accepting the uncertainty that is in the market will cause you lots and lots of unnecessary stress and frustration in the long run. At least it did for me until I started to really let go and realize that you know what, and sometimes the market doesn’t need a reason, and sometimes the market will just be the market.

So I really hope that helps, and for some of the questions out there and any other cues as always, make sure to let us know.

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