My first day on the trading floor of the New York Stock Exchange, I was given the best advice I ever got about trading: "You have to not care whether price goes up or down; you have to know what you will do to make money."
Twenty-seven years later, it's still the best advice I ever got. Preparedness is the key ingredient to profitability. Whether the price goes up or down is irrelevant; what a trader needs to worry about is being on the right side of the move.
I study only a few carefully chosen trading vehicles in futures and commodities. Call me lazy, but it makes for less effort and greater focus. Looking at the same assets every day lets me develop a rhythm for their movement, and I can gain insight into some of the nuances to increase profit opportunities. One of the things to look for is correlation between the things you trade. In this article, I'll introduce you to a special type of correlation that can be used to turn a profit when two specific instruments move in opposite directions.
Correlation describes the movement relationship between two different assets. As you can see in Figure 1 below, two assets that move in the same direction are deemed to be positively correlated. On the other hand, if the two assets move in opposite directions, they are negatively correlated. In this article, you'll see how correlation can be used in a trading strategy.
Understanding how assets move can sometimes give traders an edge and is a skillful way to take advantage of price differential between two markets.When two assets move exactly like one another, they are perfectly positively correlated. When assets move exactly opposite of one another, they are perfectly negatively correlated (Figure 1). In the real world, assets tend to have varying degrees of correlation.
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|Figure 1: In positive correlation, the two assets move in the same direction. In negative correlation, two assets move in opposite directions.|
Trading With Correlation
Once a relationship is found between two assets, a trader can take advantage of it by doing a relative comparison of the two charts. One trade that illustrates this point is based on the negative correlation between 10-year U.S. Treasury note futures (TY) and the E-mini S&P futures contract (ES). When assets are negatively correlated, you can buy one and watch the other for additional confirmation. You can also buy and sell the other, creating profits in two directions at the same time.
Figure 2 shows a perfectly negative profit picture - a 60-minute TY chart and a 60-minute ES chart. The initial trade was to go long the TY. Early in the morning, a higher pivot low was seen in the TY, marked with a green arrow, which came after a higher pivot high. This was presumptive evidence of uptrend conditions. A buy-limit order was entered on completion of the price pivot. (To learn more about this strategy, read Price Pivots Circle Big Profits.)
The next step was to look at the ES chart for negative correlation to support the trade bias and for another trade setup. Shortly after the TY entry, the ES made a lower pivot high, opposite the higher pivot low in the TY. A sell-limit order was entered to short the ES, marked with a red arrow. Being simultaneously long the TY and short the ES allowed for profit in both directions. The relationship is clearly seen in Figure 2 below by the trendlines on the structural pivot lows of the TY and the pivot highs of the ES.
|Source: Go Futures|
|Figure 2: The 10-year futures (TY) and E-mini futures (ES) compared on a 60-minute chart show perfectly negative correlation.|
As long as the negative relationship persisted, there was double confirmation that the trades were working. This is a skillful way for an active trader to take advantage of the directional difference between two markets. Being familiar with the relative movement of the TY and ES would also be helpful in terms of making faster and more confident trading decisions. Trading lower time frames is harder than it looks and the ability to make fast decisions under fire should never be overestimated.
To see a contrast, the chart in Figure 3 is an example of positive correlation on a long-term chart. Notice how the Energy Select Sector SPDR (AMEX:XLE) and Exxon Mobil Corp. (NYSE:XOM) move in the same direction. If you have the ETF XLE and shares of XOM in your portfolio, there is the same opportunity of risk as reward. The reward is doubled and the risk is also doubled; if XLE declines in price, so will XOM.
|Figure 3: XLE and XOM are positively correlated, or "coincidental", assets.|
More Opportunity to Profit
Once the two trades are on, it's time to move into trade management. There were other opportunities to profit. For example, each pivot high in the TY was a place to sell some contracts, and each higher pivot low was a point to buy back contracts. This way, it is possible to lock profits, reduce risk and continue the trade.
Because the ES is negatively correlated, the same trade management would be used in reverse. Each pivot low in the ES represents a profit taking point, and each pivot high shows another opportunity to short. Understanding trend structure is necessary for this type of trade. No indicators were used except for price pivots and the trendlines shown in Figure 2. Trendlines are used to confirm the trend and as a reference point for trade entry. As long at the trendline is not violated, you can continue to work the trade in the direction of the trend. Trendlines also provide advance notice of where price swings are likely to stall and reverse. (For more, see Track Stock Prices With Trendlines.)
Prepare and Profit
The concept of correlation can help you profit, but be aware that the market is fluid and correlations can change. Furthermore, correlation on long-term charts may vary from correlation on shorter-term charts. Instead of thinking long only or short only, think about where opportunities are present. When some assets trend up, others trend down. If they are correlated, a trader can gain an edge by comparing markets. The ability to adapt and learn with changing markets is critical to profitability.