The Trading Strategy:

Correlation — US Dollar Index Trading

Trading Strategy Implementation:

Correlation trading, just like all other sorts of trading approaches, comes in variety, and as a result it’s unfair to bulk the approaches as a single system. In order to be fair, we’re going to address one of the more common Forex correlation approaches — that being an effort to monitor US Dollar strength and weakness relative to two majors; and in doing so, look for overall US Dollar strength or weakness. This is a precarious way to trade because Dollar Indexing, as we like to it, can be problematic.

But before we get to some of the concerns we have regarding this approach, let’s begin by discussing the trading strategy itself, and in doing so outline the strategy as we understand it.

For starters, we need to define the chart we are looking at. Because this is what we consider to be an intraday approach, we’ll take a look at the 15 minute charts. These charts will certainly give us an idea of overall correlation (or lack thereof). The Dollar Index is made up of a variety of currencies and their relation to the US Dollar; but for the sake of study, we’re going to focus on the big two:  GBPUSD and EURUSD.

In order to measure US Dollar strength or weakness, we are going to look for parallel movement within a 15 minute bar.

The underlying belief is that the market moves in two general directions… for and against the US Dollar.  (This is not entirely true. There are plenty of occasions where we’ve seen both the USDJPY and the GBPUSD rise during the same session, as will be witnessed when addressing the chart below. But Dollar Index traders will tell you that the method is one where if there is deviation, trading does not take place. )

The main tenet behind this approach is this:

When the pairs do correlate, and strength or weakness in the US Dollar is apparent; it’s as simple as trading in the direction of momentum, and protecting trades with defensive trade management in order to protect equity against sharp reversals.

The overall idea, as presented above, is seemingly sound.

But let’s push a little further as we investigate….

We’re looking for periods where the market correlation between Dollar strength and weakness will lead to a high probability trade. (Remember, high probability trades are all that we can ever hope to achieve. Wasting time searching for an approach that never fails is to simply disregard the market’s ability to be dynamic. A trader looks for high probability setups, and then uses trade management that will give him or her the best long term outlook for consistent earnings without having to jeopardize the account.)

At first look, correlation seems attractive, and then, after further study, perhaps a waste of time. Which leads? And how is one to know when one is being led or simply diverging from the other? (We placed a vertical line on both charts to mark a particular time. This shows that the charts are perfectly lined up.)

Much like an indicator… any indicator… correlation seems to work at times, and fail at others.

So is that it? Do we throw it out the window?

Strategy Concerns:

It’s very obvious that the market is not exactly a place for “works every time like a charm!” If someone has an all-encompassing solution to trading, please let us know. Of course there are thousands of products (particularly trading robots) that can be purchased for a little under $200 that seem to, at least in their advertising copy, claim that the answer can be found in a program.

Two years ago Neural Networks was the fancy term for the “answer” to the market. Today it’s something else, I’m sure. I’ve long lost interest in even following the banter. I guess I can say that we Pipsters have spent enough time with enough professionals to realize a social science like the market can’t be solved. It can only be responsibly managed. And that’s exactly what successful traders do… we manage probability.

Which brings us back to correlation.

Correlation is an aspect of trading that holds obvious value. The approach we are diagramming doesn’t seemingly hold value at first glance, but for those of us with experience with correlation trading, it seemingly must be used with an understanding that the markets do correlate at times, and fail to correlate at others. This can be particular to the day, the week, even the month.

What it can not be is panacea for a technical trader who is unwilling to bother with any of the fundamentals. If watching markets fluctuate, watching them move in and out of parallel movement, then correlation may be for you. If you would rather focus on a single chart and simply measure the movement of a market on a particular day, and trade that day, then trade that day.

Conclusion:

Correlation trading is particularly advanced, and requires a firm understanding of market parallels. This has plenty to do with market dynamics relative to macro econ stuff. For instance, in the above scenario we outlined, the USDJPY had been moving opposite the EURUSD and GBPUSD, but only on a larger time frame. At the time this chart was saved as an image, the 80 to 84 area for the USDJPY looked to be a larger floor that the market had been choppily trading. To think that it will be as simple as pinning one pair to the other, and trading synchronicity fails to look at the larger factors that go into a market. The USDJPY seemed steady against the 81-84 floor, while EURUSD and GBPUSD seemingly moved in tandom.

We will leave you with another look at that same chart, and show you something that we Pipsters find interesting. Instead of looking to the areas where the markets move in tandem, we like to address the areas where they diverge.

On this particular day, the orange area, during what I believe to be the NY session, showed definite divergence in an otherwise relatively correlating day. The price action on the EURUSD during this stretch certainly seemed to hint at the opportunities presented.

Correlation trading is advanced, and requires the mental flexibility to pick up on market changes.

Please comment if there are other aspects of Dollar Index Correlation that you think we ought to consider adding to this page.