Market correlation refers to the tendency of trends in one asset to spread to other assets, resulting in changes in their prices. This phenomenon can be useful for identifying potential opportunities, but it also increases risk if not properly managed. Understanding how market correlation works can help to reduce overall risk.
Market correlation measures the degree to which assets move together. It can be used to measure the correlation between markets, sectors, or asset classes.
Correlation is typically expressed as a percentage, with a value of 100% indicating a perfect connection, meaning that the assets will always move in the same direction.
A correlation of 50% suggests that while the movements of the two markets may not always be perfectly aligned, they tend to move in the same direction.
High correlations among stocks within the same industry can make it difficult to identify a stock that outperforms its peers. Similarly, many currency pairs exhibit strong correlations, particularly when the US dollar is involved.
Types of Correlations
There are three types of correlation:
Why are Correlations Important?
Having high correlations in your portfolio can negatively impact diversification and increase overall risk. When markets are highly correlated, a downturn in one market may lead to a similar move in another, making it more likely for losses to occur in multiple positions.
This can result in higher overall risk than originally anticipated. It’s important to be aware of and manage the correlation between markets to effectively manage risk in a portfolio.
Your overall risk on a portfolio level may be much larger than you believe if you have several connected positions. Researching which markets are related and which might increase your diversification is therefore always worthwhile.
Correlations can be influenced by volatility. During periods of high volatility, markets tend to become more connected, which can increase overall risk in a portfolio. This can be challenging for diversification and risk management.
It’s important to be aware of the impact that volatility can have on the correlation between markets, and to adjust your investment strategy accordingly, to minimize your risk and maximize your returns.
Some associations are only transient, while others have persisted for years and appear to be here to stay. Here are a few such examples that you should be aware of when trading.
This is important to keep in mind when trading gold as the dollar value can greatly affect the price of gold.
When the price of Brent crude rises, the value of the NOK also tends to rise, as the country earns more revenue from its oil exports. Conversely, when the price of Brent crude falls, the value of the NOK also tends to fall, as the country earns less revenue from its oil exports.
This inverse relationship is also reflected in the USD/NOK exchange rate, as a strong NOK tends to weaken the USD/NOK exchange rate, and a weak NOK tends to strengthen the USD/NOK exchange rate.
On the other hand, when metal prices are high, miners will profit more. To do this, some traders buy mining stocks as opposed to commodities, giving them indirect exposure to metals.
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Written By: Allen Matshalaga
Allen is a professional forex trader, blogger, and online enthusiast who spends most of his time testing and reviewing legit ways of making money online and is determined to help others succeed.