Volatility and Correlations

 

Video Transcription:

Hey, traders. Welcome to Video 12 of the Forex Beginners Course. This is
Cory Mitchell. In this video, we are introducing you to volatility and
correlations, how to use them, brought to you by Investoo.com.

So monitoring volatility and correlation should be part of your weekly
routine. You don’t have to do it every single day, but at least once a
week, especially if day trading. You’re going to want to check out these
stats. It takes about five minutes just to give a quick rundown, go through
the stats. I’ll show you where they’re all available to you. So you can see
them very quickly.

You just want to see which pairs are active, which pairs are extremely
quiet or what we call dead, and which are moving together and which aren’t.
So volatility simply refers to how much price movement there is in a pair.
We want to look at daily average volatility. So is it moving 100 pips a
day? Is it moving 50 pips a day? We want to look at volatility by weekday.
So is there any sort of . . . Are Mondays extremely quiet? Are Tuesdays
very quiet? Are Wednesdays very active? So I’ll show you a quick way to see
that.

Hour of day is also important, in terms of trading hours. You’re going to
see the most volatility when major markets are open. So you want to be
aware of when those most volatile times of day are. You also want to be
aware of historic volatility. So how does now shape up, in terms of
historic volatility? If it’s very low, we got to plan for that, but we also
have to expect that volatility will eventually rise.

If volatility is extremely high compared to what it has been historically,
we got to trade for that now but expect that volatility is going to
decrease in the future. When day trading, the daily average volatility,
weekly volatility, and hourly volatility are very important. If you’re
swing trading, you don’t have to be out by any specific time. So they’re a
little less important, but you still want to monitor them.

So before we get into correlations, let’s just look at my website here,
Vantagepointtrading.com/daily-forex.stats, or you can just access it off of
the main page, Forex Daily Stats. We have a whole bunch of tools here. So
you can quickly see what the average movement is in pips. This is daily
movement. This is a 10-week average. You can change that to a more short-
term if you’re a day trader, so maybe the last, let’s say, three weeks if
you’re day trading and you want to know.

So you can see Euro/USD is moving 62 pips per day. You can scroll down the
list to see which ones are moving a little bit more. Euro/NZD, GBP/NZD are
much more active, although your spreads typically going to be bigger in
these pairs. GBP/JPY or GBP/CAD. You can see here, 93 pips. GBP/JPY 84
pips. So you can see which ones are moving and which aren’t. Euro/Swiss
typically very calm, 21 pips per day.

So here is hourly volatility. This is in GMT or Greenwich Mean Time. So
you’ll have to convert it to your own time zone, but you can see what the
typical movement is for each one of these hours. So we can see this is when
the US market is opening, and we have about 25 pips of volatility for that
hour. After that, it tapers off into when the markets . . . It’s open 24
hours a day, but you have the US and London closing, and it tapers off
after that.

Below that, we have Euro/USD volatility per week, and you can click on any
one of these to change it to whichever pair you want. So let’s look at the
Euro/JPY. So we see Wednesday is typically the lowest volatility day. So
that is something you want to be aware of. If you’re looking at this stat,
let’s just move back to the Euro/USD for a minute.

So you’re thinking 62 pips per day. You might be using that to potentially
factor in some of your profit targets. On Thursday, it’s going to be a lot
easier to reach that because we’re moving about 90 pips per day. On
Wednesday, we’re only moving about 50 pips per day. So that’s the average
over the last few weeks.

Mondays are typically a little more volatile, and Fridays are fairly quiet
again. So we want to factor that in when we’re day trading. When you start
out the day, take a quick look at this and just make a note. Okay? We’re
trading on a Wednesday. So it might be a little less volatile today,
probably going to be less aggressive with my targets.

If I’m trading on a Thursday, I could be a bit more aggressive with my
targets because I have more movement. Here, we have historical volatility.
So if we scroll out to a longer timeframe, we can see here on the Euro/USD
we are trading at one of the lowest volatility times in the last few years.
Back in 2011, we had volatility of more than 150 pips per day. It’s been
slowly dropping down to about 50 pips per day recently. Now, we’re starting
to creep back up.

So that’s something you want to be aware of. Is volatility going to
decrease much from here? That’s probably unlikely, based on the few year
history here. It’s more likely that we’re going to start creeping back up
towards this 100 area. So keep this in mind. If we were trading up here at
about 150, that’s probably too high. We’d want to gravitate back toward
that 100. So keep that in the back of your mind.

We have a tendency to gravitate back towards the mean, the mean being about
90 to 100 pips per day over the long-term in this pair. That’ll be
different for each pair that you pull up. Let’s look at the NZD/USD for a
second. Up here, high as about 70 pips. Low was about 45 pips to 50 pips.
So the average in there is likely around this 60-pip mark, which we’re
trading at right about now.

If we look at a longer term, probably going to move back up into this 100
area. So that’s something you want to keep in mind. Volatility is on the
lower side right now. If we move back up into this 150 or 130 area, that’s
probably likely a little high. Then we’ll look for it to correct back down.
So always something you want to keep in the back of your mind.

Now, let’s move onto correlations. You can also see correlations on this
page. So let’s go through what these tables mean. So a correlation is how
much one pair moves with another. A correlation of 100 means the pairs move
exactly the same. When one pair goes up, the other goes up. When one goes
down, the other goes down.

A correlation of negative 100 means the pairs move exactly the opposite.
When one pair goes up, the other pair goes down. When one pair goes down,
the other one goes up. Correlations of, say, 60 or 20 or 30, minus 60,
minus 20, minus 40, mean the pairs don’t really move together. It’s called
a weak correlation. So the 100s are your strong correlations. As it moves
towards zero, those correlations get weaker and weaker.

So at about 60, we no longer really care. There’s a loose correlation there
at about 60, but it’s not really anything that we’re going to be too
concerned about. If you have a correlation of 20 or minus 20, there’s
really no rhyme or reason to how those pairs move together. They’re moving
independently of each other.

Correlations of 70, greater than 70, or less than 70, so if we’re looking
at 70, 80, 90, 100 or negative 70, negative 80, negative 90, negative 100
those are noteworthy correlations. It means those pairs do move in a
similar fashion. So we want to be aware of them.

So let’s pull up our table again. So here, we can look at hourly
correlations, daily correlations, and weekly correlations. The hourly
correlation is not going to be too consequential, but the daily and long-
term correlations we do want to focus on.

So we can see Euro/USD, obviously is 100% correlated with itself, but the
British pound and the Euro/USD are not at all correlated at the moment. So
there is a 7.2 correlation. You can think of that almost as a percent, so
7.2% correlation. That’s not really what it is, but you can think of it
that way. So there’s almost no correlation there.

Typically there is, though. If you look at over the long-term, they do move
together. So over the short-term daily, they’ve diverged, but typically you
do see a fairly strong correlation between the British pound, US dollar,
and the GBP . . . or sorry, Euro/USD and the British pound/US dollar. So
over the long-term, 86.3 correlation.

Let’s look at ones that are correlated. The USD/Swiss and the Euro/USD, so
we’re going down Euro/USD, across USD/Swiss. We see a negative 98.5
correlation. So what that means is that when the Euro/USD goes up, the
USD/Swiss goes down nearly all the time. So it’s not quite 100%
correlation, but that’s about as close as you’re going to get.

So very strong inverse correlation, what we call it. So Euro/USD goes up,
US/Swiss goes down. Euro/JPY, Euro/USD, also a strong correlation. So when
the Euro/USD goes up, we would also expect the Euro/JPY to go up because
there is a 91.9%, not percent, but correlation there.

AUD/USD and Euro/USD, very low correlation, 2.9. Let’s look for a few other
ones, any other strong correlations. These are all weak. We can see lots of
small numbers, 55, 7, 70. So British pound/USD and the British pound/JPY,
if we match those up, 70.3. So that is on the verge of being a strong
correlation. It’s noteworthy.

USD/Swiss and Euro/JPY, inverse correlation of 90.5. So when the Euro/JPY
goes up, we would expect the USD/Swiss to go down. Same goes for the weekly
chart. This will give you a longer term view of how these pairs interact
together. It is useful for noticing discrepancies because sometimes you
will get these discrepancies you can see here, where the Euro/USD and
British pound/USD are not moving together right now.

But on a historic level, on a longer term chart, they do typically move
together. So that is something you want to note. This is a bit of an
anomaly at the moment, but eventually those pairs are likely to converge
again and start moving together, based on this weekly correlation.

So that’s how we read the table. Now, how do we use that? If pairs are
positively correlated, you can buy one and sell the other to create a
hedge. So if the British pound and . . . or the Euro/USD and the British
pound/USD have a strong positive correlation, as we see on the weekly
correlation table, you can buy one and sell the other to create a hedge.

What a hedge means is just you’re using one to offset your losses. So say
you have a long position in the Euro/USD. There’s a big news announcement
coming out. You don’t necessarily want to get out of the position, but you
want to hedge off some of the risk. What you can do is you can take your
long Euro/USD, take a short position in the British pound/USD to
potentially hedge your position. So when one makes money, the other will
lose money.

If pairs are inversely correlated, you can buy both or sell both to create
a hedge. So an example of that was the Euro/USD and the Swiss Franc are
usually Euro/USD/Swiss Franc are often inversely correlated usually to a
strong degree. So you can buy the Euro/USD and buy the USD/Swiss. When one
goes up, the other is going to go down. So you’re going to make money on
one, lose money on the other.

So hedging, not something a lot of traders do, but it is something that you
can do. Correlations only look at whether prices move together, not the
magnitude of the moves. Just because the Euro/USD goes up when the
USD/Swiss goes down doesn’t mean they will form a perfect hedge. The
Euro/USD is normally more volatile. So the Euro/USD may drop 80 pips, while
the USD/Swiss only rallies 55. In that case, it wouldn’t fully offset your
loss. So you don’t have a perfect hedge.

So in terms of magnitude, while it says here that the USD/Swiss and
Euro/USD are nearly perfectly inversely correlated, if we go to our table,
we can see the Euro/USD moves 62.5 pips a day, while the USD/Swiss only
moves about 47.4. So we do not have . . . It does not factor in magnitude.
So that’s why we have to look at volatility and correlations. So we can see
how these pairs interact with each other, both in how they move and how
volatile they are.

You can also use correlations to monitor your exposure. Say, for example,
you have five long positions, and they all have strong positive
correlations. So you happen to look at the correlation chart after you’ve
got into these five positions, and you notice that they all have strong
correlations of 70, 80, or 90 with each other.

What that means is that you’re overexposed to probably one pair. So really
what you’ve done is instead of taking five independent positions, since
those positions are all correlated, you’ve actually risked five times as
much. So say you risk 1% on each one of those five trades. What you’ve
actually risked is 5% because you haven’t taken an independent trade. All
those positions are likely to act as one, since they’re highly correlated.
So if you lose on one of those positions, you’re likely to lose on all of
them, which means that your risk is actually more than you thought it was.

Being long and short, inversely correlated pairs create the same problem.
So if you go long the Euro/USD and short the USD/Swiss, since they are
inversely correlated, you’re going to end up with the same problem. You’ve
basically taken two of the same trade.

If there’s a strong correlation, positive or negative, you can use this
information to choose the better of two trades. Since correlations make
them similar trades, you want to go long. If you want to go long, go long
in the stronger one or the one that has more volatility. Or if you want to
go short, go short the weaker one.

So when you compare charts . . . Let’s say you want to go long the
Euro/USD. Since you know the Euro/USD is highly inversely correlated to the
USD/Swiss, you can also take a short position in the USD/Swiss. It would be
almost exactly the same trade as the Euro/USD, since they move together.

But now, you have two options. You can choose the long in the Euro/USD or
the short in the USD/Swiss, and you can look at the chart to see which one
offers a better place for your stop, which one offers a better entry point,
which one offers a better target. So you have a choice there of choosing
one which gives you the slightly better trade, because they move very close
to the same, but not identical, which means that they’re going to give you
slightly different trade setups, and that can be favorable.

When two pairs are strongly correlated over a long period of time, these
correlations can be used to confirm each other. When one pair breaks out of
a range, the other should as well. If it doesn’t, it indicates the breakout
could be false. So if we go back to our table . . .

So we have a . . . Where do we have a strong correlation? Euro/JPY and
Euro/USD. So they have a fairly strong correlation. If the Euro/JPY is
moving very strongly higher, we would expect the Euro/USD to be moving
higher as well. If it isn’t, that indicates something may be wrong with one
of these pairs, and we could be in for a reversal. So if the Euro/USD is
shooting higher, but the Euro/JPY isn’t, watch for that move in the
Euro/USD to be a potential false move.

So when you have high correlations, they can help confirm each other. If
the Euro/USD is going up, the USD/Swiss should be going down. If it isn’t,
that indicates that something may be wrong. Either the Euro/USD is going to
collapse back, or the USD/Swiss is going to have to make its move
eventually. So those help you confirm what other pairs are doing. If
there’s low correlations, you’re not going to have much help from that.

So those are what you want to look through. Get used to reading through
these tables. Be sure to check them. Wherever you get the information from,
look through it at least once a week, just so that you have a good idea of
what the average pip movement is. It’ll help you notice . . . maybe adjust
your strategies a little bit.

If you’re trading in an environment where it’s always moving 100 pips, and
then you start to notice it’s falling off and we end up with this at about
62 pips per day, you’re going to notice that in your trading. Your profit
targets may not be getting hit, other things like that.

So you need to be aware of volatility, so that you can adjust to it. You
also want to be aware of any correlations that you are trading, just so
that you don’t overexpose yourself to one currency or end up taking
basically the exact same trade by, let’s say, going long the Euro/USD and
short the USD/Swiss. That is basically the same trade.

So you want to avoid overexposure situations like that, and you also want
to use these to confirm any trades you may have, because they can help you
spot when a move may be false or something like that.

So check out these. Get used to reading these tables. Monitor the long-
term, daily, and hourly. Also at the bottom here, we have a few other tools
that you can see open positions on orders and how the sentiment, what we
call it, on pairs. You can also see the relative strength of currencies to
others. So this can also help you, a few other tools to help you assess how
certain pairs are moving, how strong they are.

So get in your demo account. Try out a few of those things and get used to
reading these tables. Until next time, happy trading.

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