A market correlation is when two markets move together. This could be in the same or opposite direction. Understanding the how and why it occurs can help you identify the future price direction of an instrument.
Correlations are never 100% accurate and can break down under different market circumstances but when used right they can help you make better trading decisions.
Let’s look at a major contributor related to two major instruments (The US Dollar and Gold)
The Negative Correlation between the US Dollar and Gold
The US dollar and gold move in opposite directions (negatively correlated). The graph at the top is the USD/JPY pair and we have the gold chart at the bottom. Here we see 7 years of price history. An opposite movement.
So why is this?
When markets are performing well investors will always chase the best yield available and if the best yield is coming from the stock markets, investors will invest their money there.
You can only invest in US equities with US dollars so to do that these investors need to buy US Dollars. This increases the demand for the US Dollar which pushes up the price of the US Dollar.
Gold is considered a haven asset class: however, it does not offer a yield. When stock markets are rising investors will sell their gold holdings to access this better yield which will result in the price of gold falling. So, the dollar rises and gold falls.
A third consideration in this correlation is the Japanese yen which is also considered a haven asset in times of uncertainty. However, in our example above if stocks are rising money will also flee from the Yen which is why we are using the USDJPY pair in our example.
Not only are investors buying the Dollar to access the stock markets but also selling the YEN as they do not believe a haven such as the YEN is needed when stock markets are rising.
Below is a more recent example of the negative correlation between the USD and Gold over the last 10 days (16th Feb – 26th Feb 2018)
There will always be other variables going on such actions from Central Banks that will impact these correlations and expose them as not being perfect all the time.
That said, nothing is perfect in trading, it is all about connecting different pieces of useful data and using it to help you make better trading decisions. Correlations is just one!
The USD and XAU are intricately tied. But what if you don’t know the fundamentals of trading forex? Here’s a quick guide to help you on your trading journey.
When you launch your trading platform, you will first notice the price charts of the most popular currency pairs which will likely include the EUR/USD, GBP/USD and USD/JPY. The chart is just a representation of the price movements and can be adjusted to different timeframes as well.
You will also notice that each pair is quoted at two different prices. This is the Bid and the Ask price. For example, if you see EUR/USD = 1.1231 / 1.1235 – this means that the Ask price or the one on the right is the price you will be buying the pair if you believe the base (Euro) currency will go up. Instead, if you predict the Euro will go down, you can go short or sell it at the Bid price which is the price that buyers in the market are looking for.
As you can see there is a small difference between the two prices and specifically a 4-point differential 1231 – 1235 = 4 and this is called the spread. The spread is the fee your broker charges for executing a trade on your behalf and is the main cost of trading forex.
Going back to our example, if you bought the EUR/USD at 1.1235 and the price went up to 1.1250, you would have made 15 points of profit. In forex these points are called pips (percentage in point) and they are the smallest amount of movement a currency can make.
It’s important to note that each pip can be assigned a dollar value which depends on the asset you are trading and your broker’s specifications.
So, we made 15 pips of profit and we closed the trade. Now, we need to deduct the spread or the fee in order to see our total. Since the spread for this asset was 4, then 15-4 = 11 pips. Each pip for EUR/USD is equal to $10 and therefore 11 pips x $1 = $110.
Discover the complete education package when you open a live trading account with us.
