Correlation Strategy – Forex Academy

Introduction

A correlation coefficient is a number that describes the extent to which two instruments are correlated to each other. The number ranges between -1 and +1. This number moves from periods of positive correlation to periods of negative correlation. Located on one end of the scale, +1 is considered a state of the positive correlation between two instruments.

If the number is anywhere between 0 and +1, the two assets are said to move in the same direction, with a certain degree of positive correlation. On the other end of the scale, -1 is considered a state of negative correlation between two instruments. If the number is anywhere between 0 and -1, the two instruments are said to move in the opposite direction, with a certain degree of negative correlation.

The strategy we will be discussing today seeks to exploit the inverse correlation between the dollar index and Gold’s price. According to the World Gold Council, Gold tends to rise when the U.S. dollar falls. It is observed in the past that the correlation coefficient for Gold and the dollar index was between -0.6 and -0.8. This means if the dollar index is up, there is a 60% to 80% chance that gold prices would come down. In contrast, if the dollar index is down, there is a 60% to 80% chance that gold prices would come down. Let us see how the strategy works.

Time Frame

The commodity correlation strategy works well in the Daily (D) time frame. This implies that each candlestick on the chart represents the price movement of one day.

Indicators

We will be using the ATR indicator in the strategy. No other indicators are required for the strategy.

Currency Pairs

There are two charts we need to focus on in this strategy. The first one is the spot Gold or XAU/USD, and the second one is the chart of the dollar index.

Strategy Concept

The dollar index’s price action is used as a reference to initiate a trade on the XAU/USD. Technical levels of support and resistance on the dollar index chart are used to spot long and short trades on XAU/USD. If the price closes below the support on the dollar index chart, a long trade is initiated on the XAU/USD the following day. Similarly, if price closes above resistance on the dollar index chart, a short trade is initiated on the XAU/USD the following day. The risk-to-reward of this trade is 1:2. A bigger target can be achieved by allowing the trade to run its course.

The strategy is very simple for those who have a basic understanding of support and resistance. Another reason behind its popularity is that it does not involve the usage of complex indicators. The trade setups are not formed too often as we are using the daily time frame charts. Hence, a lot of patience is required for the application of the strategy.

Trade Setup

Here are the steps to implement the commodity correlation strategy. In both the instruments, we will be using the daily time frame chart only.

Step 1

The first step of the strategy is to open the dollar index’s daily time frame and mark key areas of support and resistance on the chart. If one is looking for ‘long’ trades, the identification of the support area is crucial. And if one is looking for ‘short’ trades, identification of ‘resistance’ trade is crucial. After marking out of the lines, wait for the price to breakout or breakdown. In case of a breakout, we will look for ‘short’ trades in ‘gold,’ and in case of a breakdown, we will look for ‘long’ trades in ‘gold.’

We have taken an example of a ‘long’ trade where we will be executing the steps of the strategy. In the below image, one can see that the price has broken below the long term support.

Step 2

Next, we open the chart of XAU/USD, where we look for ‘long’ or ‘short’ entry. We enter for a ‘long’ in ‘gold’ on the following day of the dollar index’s break of support. Similarly, we enter for a ‘short’ in ‘gold’ on the following day of the break of resistance in the dollar index. The entry is taken right at the opening candle on the next day.

In our case, we are entering for a ‘long’ in ‘gold’ on the following day since the price had broken the dollar index’s support on the previous day.

Step 3

In this step, we determine the take-profit and stop-loss for the strategy. The stop loss is mathematically calculated where it is placed at the amount obtained after multiplying 2 to the value of the ATR indicator on the previous day. This means if the ATR value is 30, then stop loss will be set 60 points away from the current market price (CMP). The take-profit is extended up to a point where the trade results in a risk to reward ratio of 1:2. As mentioned earlier, since this is a long-term chart, the trade has the potential to give higher returns.

We can see in the below image that trade has almost reached our ‘take-profit’ where this is the current state of the market.

Strategy Roundup

Part II of the commodity correlation strategy seeks to take advantage of the negative correlation between the dollar index and gold prices. Using the dollar index as a reference, we are activating trades on the XAU/USD pair, which is nothing but the price of spot gold.

However, the interest rates announcement by the Federal Reserve will try to keep the inverse relationship between the U.S. dollar and Gold. This strategy is ideal for traders around the world who do not have time to watch the markets on a daily basis. The strategy can also be used to look for investment opportunities in Gold.

Introduction

Oil is one of the largest commodities in the world that is traded heavily. The reason for high liquidity is that it is a basic necessity. It is needed to run factories, machinery, ships, and cars. Canada is one of the largest exporters of Oil, and it forms a major part of the total volume of commodities exported. Due to these reasons, Canada is positioned in the world’s top ten oil-producing nations, and as a consequence, it’s economy is severely impacted when oil prices decline. Many traders today predict the movement of the Canadian dollar using the price of Oil.

When oil prices rise, the Canadian dollar tends to strengthen. Similarly, when oil prices are low, the Canadian dollar tends to weaken. Japan, in contrast, is considered as the net importer of Oil. So, when oil prices rise, Japanese yen weakens, and when oil prices drop, Japanese yen strengthens. Many traders are not very comfortable trading Oil due to the volatility it possesses.

An alternate and improvised way trading oil directly would be to utilize knowledge of oil prices to trade the CAD/JPY currency pair. As Canada is the net exporter and Japan is the net importer of oil, oil price becomes a major indicator for the movement of the CAD/JPY currency pair. That is why we have named this strategy a ‘Commodity Correlation Strategy.’ Let us dive into the strategy and explore the steps involved.

Time Frame

The commodity correlation strategy works well with the daily (D) and weekly (W) time frame charts. Swing trading is the most suitable trading style for this strategy as it has a long-term approach to the price. Therefore, the strategy cannot be used for day trading or on 4-hours’ time frame chart.

Indicators

We use just one technical indicator in this strategy, and that is the Average True Range (ATR) to set the stop loss for the trade. We don’t use any other indicator during the application of the strategy. If one is not familiar with the ATR indicator, it is recommended to refer our article on ATR before understanding the strategy.

Currency Pairs

This strategy can be used with CAD/JPY currency pair only, with the movement of oil prices as our leading indicator.

Strategy Concept

The price movement of crude Oil is used as a reference to catch a ‘trade’ in CAD/JPY currency pair. Key levels of support and resistance on the crude oil chart are used to spot long and short opportunities in CAD/JPY pair. If price closes above resistance on the oil chart, a long trade is activated on the CAD/JPY the following day. Similarly, if the price closes below support on the oil chart, a short trade is triggered on the CAD/JPY the following day. The risk to reward of trade taken based on this strategy is a minimum of 1:2, which is above normal. A bigger target can be achieved by allowing the trade to run.

Trade Setup

In order to explain the strategy, we focus on the price chart of crude Oil and CAD/JPY currency pair. We are not concerned with any other forex pair. The strategy can be easily understood by those who have basic knowledge of support and resistance.

Step 1

Firstly, we need to open the chart of crude Oil and then find key levels of support and resistance. After marking support and resistance levels, we wait for a breakout or breakdown of the range. After the breakout happens, make sure that the breakout is real and a faker. A close candle well above the resistance area gives us a confirmation of the breakout, and thus we can expect a continuation of the price in the direction of the breakout.

The below image shows how the breakout should be along with the confirmation candle.

Step 2

Now, we need to open the chart of CAD/JPY currency pair and locate the price on the day when the breakout took place on the oil chart. Since the breakout on the oil chart is above the resistance, we will ‘long’ in CAD/JPY currency pair after a suitable confirmation sign from the market. A bullish candle on the next day is the confirmation signal for going ‘long.’ In a case of a breakdown below the support, a bearish candle in the CAD/JPY pair on the next day of the breakdown is suitable for going ‘short’ in the pair.

In the above example, we see the formation of a bullish candle on the following day, which triggers a ‘buy’ trade. Let us see what happens further.

Step 3

In this step, we determine take-profit and stop-loss levels for our strategy. The stop loss for this strategy is calculated by multiplying the value of ATR by 2. The stop loss is placed by the number of pips obtained after performing the calculation. The take-profit is placed at the price where the risk to reward of the trade will be at least 1:2. However, in most cases, the trade has the potential to provide move higher.

In this example, the risk to reward of the trade was 1.5 as the major trend was down.

Strategy Roundup

Using the Commodity Correlation Strategy, traders can take advantage of the positive correlation between Crude oil prices and the CAD/JPY currency pair. This strategy is especially suitable for traders who want to trade in Oil but do not enjoy the volatility associated with it. This strategy is also suitable for traders who do not have the time to day trade and prefer long-term positions in the pair.

Crude Oil has the highest correlation with CAD and JPY Forex pairs. Hence we have considered these asset classes. You can use this strategy for different Forex pairs depending on which commodities they are correlated with. We hope you found this strategy informative. All the best.