The Pattern Trap
Correlations can help you trade, but they can also come back to bite.
Sorry, Hayley Mills, it's not just parents who get trapped.
Currency investors spend a lot of time looking for correlations, either between currencies, or between currencies and other assets. It's often useful because a view on one asset can point the way to a trade on the other - but these patterns can also mess you up.
Take the euro-dollar pair and the S&P 500 index. Alan Ruskin, global head of G10 foreign-exchange strategy at Deutsche Bank, has examined the performance of the two over the last several months, and found a 79 percent positive correlation in daily percentage changes. Nice, right? But the euro has fallen some 6 percent over that time, while the stock index rose 8 percent.
What happened? In a word, volatility. The euro has tended tofall more than the S&P on a given day, and also rise more. But because the falls are steeper, the rises don't fully compensate, and the euro has seriously lagged.
"The last three months provided a clear view of the problems and the opportunities associated with trading correlation and associated products," Ruskin says.
To avoid this pattern trap, make sure you look at all kinds of correlations, not just the ones that indicate the direction of trades. Good luck out there.
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