There are two main types of market relationships or correlations that you need to be aware of when trading foreign exchange markets. First is correlation analysis. Second, Forex relationship to commodity prices and equities. Understanding market correlations will help you generate trading opportunities and manage risk.


Currency correlation
Currency correlation is defined as a statistical measure of how two currency pairs move in relationship to each other. Correlation coefficients range between -1 and +1. Correlation of +1 implies that currency pairs will move in the same direction. Correlation -1 implies that currencies will move in opposite directions. The closer the number is to 1, the stronger the positive correlation. Conversely - the closer the number is to -1 the stronger the negative correlation. If the correlation is 0 the movement of the currencies is said to have no correlation.


Currencies trade in pairs
Currencies trade in pairs. No single currency pair trades independently of the other. Some currency pairs will move in tandem. Other currency pairs will move in opposite directions. For example if you are trading EUR/JPY cross you are also trading a derivative of the EUR and JPY. The cross should be closely correlated to the movements in the underlying currencies. If you are trading EUR/JPY and the correlation to the EUR and JPY is close to 1 you have decisions to make about how you may want to trade the EUR or JPY because these currencies would likely move in the same direction as the cross. This will impact your profitability.


There are three main ways correlation studies can help in your trading
1) Negative correlations will help you avoid taking positions that go in opposite directions and tend to cancel each other (you can also use negative correlations as a hedge taking advantage of the negative correlation between two currency pairs) 2) a positive correlation can be used to add to your position, basically doubling up your exposure by trading two or more currencies that trade in the same direction and 3) you can use the correlation studies to diversify risk.


Portfolio diversification
The main assumption behind the theory of portfolio diversification is: if assets in your portfolio are not positively correlated you can limit your exposure because some positions will be rising while others are falling. Understanding currency correlations and this basic assumption of theory of portfolio diversification will help you gauge risk exposure of your Forex positions.


How to set up a correlation study
Most major Forex firms will run correlation studies and update them frequently. You can set up the correlation study yourself by downloading free historical currency data and dropping it in the excel spreadsheet using the correlation function.


What should I be looking for in the correlation studies?
To benefit from the use of correlation studies all you really need to be looking for is whether currencies are heading in the same direction our opposite direction. Based on your trading strategy, you can use this information to increase exposure or to limit your risk. The closer currency correlation is to +1 the more the position works to your advantage. The closer the correlation to -1 more the position will work against you.

Here is an example of what a correlation study looks like



Leverage and Diversify
The two main ways most traders use correlation studies is to increase leverage (position size) and to diversify the risk of your positions.

Note in the table above EUR/USD had a strong .94 one month correlation with AUD/USD and a weaker 0.32 correlation with USD/CAD. You might use this information and buy AUD/USD if you already buying EUR/USD as these currencies will tend to move in the same direction increasing your leverage (size of your position) or, you could buy USD/CAD to partly hedge your exposure in long EUR/USD because of the moderate negative correlation to EUR/USD.


To sum up so far
If all this sounds complicated it really isn't. All you're trying to do is look at correlation studies to determine whether a currency pair is positively or negatively correlated. The closer the correlation to 1 the more positive the correlation and the closer correlation to – 1 the more negative the correlation. What you do with this information will depend on whether you're trying to add to a Forex position, hedge a Forex position or diversify risk. Currency correlations are measured over a specific time periods, and it is important to bear in mind that these relationships reflected in the numbers will change over time. These correlations will have to updated and monitored regularly. The correlations can help you manage risk and increase leverage of your trading positions.


Forex relationship to crude commodity prices and equities
Over the past year there have been a number of correlations that emerged in the FX markets to the price of crude, the CRB, and equity markets. The strongest correlations that emerged was .97 correlation of the EUR/USD and price of crude, a similar strong positive correlation between the price of the USD/JPY and equities and the well-established strong positive correlation of CAD and AUD to the CRB. You can calculate the statistical correlation between crude, commodity prices and equities in similar fashion to the correlation studies noted above and use advanced charting tools to graph these relations and plot the relationships. Of late, the EUR has been weakening as crude oil rallies, this is important sign of the possible divergence in the recent crude /EUR correlation. The JPY /equity market correlation and CAD/AUD correlation to the CRB remain positive in the early 2009.


How would you use these correlations?
If you've been trading Forex the last few years you could have monitored the price direction crude and taken a position in the EUR based on the direction of crude. Or, you could have monitored the CRB taking a position in the CAD based on the direction of the CRB. Or, you could have monitored equities and taken an opposite position in the yen. You will want to continue to monitor these reason relationships looking for signs of a possible breakdown in the relationship which could be a signal of a change in market sentiment. For example, if the yen stops trading inversely to equities it could be a signal that the market has shifted focus to domestic economic fundamentals in Japan away from focus on risk appetite in risk aversion. Equity markets are seen as the main gauge of risk appetite/ risk aversion. The Yen has been trading inversely to the level of risk in the market. So if you can forecast for react to price movements in food, the CRB and equities you may gain an advantage and improve your chances of profitability trading. The more you know about what relationships are influencing the direction of currency the greater opportunity for you to capitalize on our market correlations.


Why use these correlations?
Monitoring these relationships is just another way to try to determine where the market may be headed. These relationships may give you an advantage when trading because of their close correlation to the Forex market price direction. Let's shift gears and talk about market sentiment.


Market Sentiment
One of the key goals of trading is to determine whether market sentiment is bullish bearish or neutral. This is the heart of market sentiment. Is the trade expecting the market to go up, go down or trade sideways? The strength of the trades’ conviction about the direction of the market will give you valuable information on the viability of the markets trend. Market sentiment is one of the most important factors that drive the Forex market. In a previous article we discussed Elliott wave theory and how optimism and pessimism about market direction is reflected in waves. This is just another way of saying that psychology of market often drives price direction.

Let's take a look at some of the tools that you may use to evaluate market sentiment.


Volume and open interest
Two major traditional methods of measuring market sentiment are open interest and volume. Because there is no centralized Forex cash market trade there is no way to accurately measure open interest and volume in Forex markets. One of the ways to overcome this hurdle is to look at open interest of currency futures markets. Open interest is defined as the number of future contracts that have not been exercised, expired or unfilled by delivery. Volume is defined as the total number of contracts transacted on an average day for a particular currency.


How do I use open interest and volume in my trading?
If the market is rising, you want to see open interest rising as confirmation the trend is up and likely to continue. If open interest is rising and the market is not rising this could be a sign that the market is set for downturn. Similarly, volume is an indicator used to confirm market trend. Rising volume with rising prices is strong indicator that the trend will continue. Rising volume and sideways price movement the price action is indication that the trend may be about to change. Open interest and volume are tools of technical analysis. In an earlier article we looked at a number technical tools try to determine market trend and sentiment. These tools included relative strength index, oscillators moving averages and cycle analysis. All these technical tools can be used to try to evaluate market sentiment.


COT Report
Another tool used to determine market sentiment is Commitment of Traders for the futures exchanges. The Commodity Futures Trading Commission (CFTC) publishes the commitment of traders (COT) report every Friday. This report measures the net long and short positions taken by traders in the futures markets. The COT report is great measure of market sentiment because it includes large trader’s positions. Looking at what large traders are doing may give you read of “the smart money” in the market. You can go to the CFTC website and get overview of what's included in report. Here is the address.


Here's a look at the key components of the COT report
Basically COT breaks down non- commercial traders which include individual traders and hedge funds and financial institutions, commercial traders, which includes businesses that use the markets to hedge, the net number of long contracts and short contracts, open interest, non reportable positions, the number of traders and reportable positions. COT report tells you the positions taken by the traders in the individual currency markets and who those traders are. Knowing what position the traders are taking and what type of traders are taking those positions is valuable information for determining market sentiment.


The major benefit of the COT report
One of the key benefits of using commitment of traders is you can look at the difference of change in net open interest in the long and short positions from the previous week. This information will give an indication of market sentiment showing whether the trade was adding to positions in a currency or subtracting positions from a currency. If you match the movement and the net change in open interest against the price of a currency movement, you can get an indication of whether currency futures traders are becoming more bullish or bearish an individual currency. To use the COT report to trade cash Forex markets you have to assume that the currency futures market represent a microcosm of market sentiment of the broader Forex market.


Bullish consensus
Another way to try to measure market sentiment is using bullish consensus. Bullish consensus is a weekly newsletter that takes a survey of futures market sentiment. Bullish consensus sentiment indicators range from zero to 100. The closer the sentiment reading to 100 more a market is overbought. The closer the sentiment reading is market is to zero the more market is oversold. If bullish consensus is above 90 you would be looking for the market rally to slow or reverse. If bullish consensus is below 10 good look for the market declined to be nearing its end and possibly set to reverse and go higher.


Why is market sentiment worth watching?
Markets are driven by crowd psychology. Crowd psychology at major turning points is usually wrong. If sentiment is overwhelmingly bullish or bearish the market may be set for a change in direction.

When market sentiment reaches extreme high point or low point in sentiment this may be a sign that the market is overbought or oversold. You can use market sentiment as a key indicator to determine whether to stay with your trade, exit you trade or take contrarian trading position. Analyzing market sentiment can help also help you stay right side of the market or avoid getting run over by sudden change in market.


Summary
Correlation studies can be used to diversify risk or add additional leverage to your Forex positions. Market sentiment is best used at market extremes and may be used for establishing contrary positions. Market sentiment can be helpful in keeping you on the right side of a market. Forex markets are often driven by crowd behavior. Evaluating market sentiment can help you gauge how crowd behavior may impact the direction of the currency.


Test your knowledge

1. True or False
   Correlation studies can help you determine whether currency pairs move in the same or opposite directions.


2. True or false
   The three main ways that correlation studies can help you in your Forex trading in are, to avoid taking opposite positions, add to positions and diversify risk.


3. True or false
   Market sentiment is usually at an extreme when a market trades at highs and lows.


4. True or false
   The CFTC commitment of traders report reflects positioning in the Forex spot market.


5. You may try and _____ a currency if bullish consensus was that 95.
1. Buy
2. sell
3. stand aside
4. add

1. True
2. True
3. True
4. False
5. b, sell