Correlation in financial markets: What is it and how to use it?

It is important to understand the markets and how they interact with each other. Correlation between markets is a critical source of information. Correlation is the most widely used statistical measure of the relationship between markets. However, care must be taken to avoid misinterpretation and erroneous conclusions.

Correlation in financial markets

Correlation in the world of financial markets determines how and when the prices of different financial instruments move in relation to each other. This applies to assets such as stocks, currencies and commodities that may show similar movements. Correlation shows the behaviour of markets when they move simultaneously in one or more directions. For example, positive correlation occurs when two currency pairs move in the same direction.

GBP/USD and EUR/USD are examples of currency pairs with positive correlation, when one pair trades down, the other pair also shows similar movement. Negative correlation occurs when markets move in opposite directions. An example of this correlation is government bonds and interest rates: when rates rise, bond prices fall. This explains why investors consider correlations when analysing markets and developing trading strategies.

Types of correlation in the stock market

There are three main types of correlation between markets in the stock market:

• Positive correlation: If prices in two markets move simultaneously in the same direction, up or down, they are positively correlated. Positive correlation can be strong or weak, depending on historical data;
• Negative correlation: If one market tends to fall when another market is rising, then there is a negative correlation between them. The level of negative correlation can be determined using a coefficient that ranges from -1 to 0;
• Zero correlation: Zero correlation means that there is no relationship between the markets. Price movements in one market have no significant effect on price movements in another market.

It is important to realise that correlations can change over time: currency pairs or stocks that showed a high correlation one year may show a negative correlation the next.

Correlation between different markets and its impact on investments

It is common to find correlations between currency pairs and the most actively traded commodities. For example, the Canadian dollar correlates with the price of oil, as Canada is a major exporter of oil. At the same time, there is a negative correlation between the Japanese yen and the oil price because Japan imports all of its oil. Similarly, the Australian dollar is highly correlated with gold prices and the New Zealand dollar is highly correlated with agricultural futures such as corn futures.

Other examples of correlation can be found between airline stocks and the price of oil. When the price of oil goes up, so does the price of jet fuel, which in turn affects the price of airline tickets. U.S. airlines are the most likely to suffer from higher fuel prices because most are not immune to price increases, unlike their European and Asian competitors.

In addition, a negative correlation is often seen between the stock and gold markets. When stocks go up, gold tends to go down, and vice versa. This is because gold is considered a safe haven for investors in times of uncertainty, when they prefer it over relatively riskier assets such as equities.

Correlation plays an important role for investors as it helps in asset allocation. Combining investments with low or negative correlation reduces the volatility of the portfolio, which allows the trader or portfolio manager to invest more aggressively. This asset allocation to reduce volatility to an acceptable level is called portfolio optimisation.

Correlation-based trading strategies

Investment strategies based on correlation play an important role in trading, but it is important to realise that trading timing is crucial. Sometimes the correlation between assets deteriorates and if an investor does not react quickly, it can lead to losses. The concept of correlation is a key element of technical analysis for investors seeking to diversify their portfolios, especially during periods of severe market uncertainty.

During such periods, portfolio rebalancing may involve replacing assets with positive correlation with assets with negative correlation. This helps neutralise price fluctuations in the markets, reducing both risk and potential return. For example, stocks and put options on those stocks exhibit a negative correlation: as the price of the stock falls, the value of the put option rises, making it a useful tool for hedging risk.

To summarise: How to use correlation in financial markets?

Proper risk management based on correlation helps reduce overall portfolio risk and maximise returns by investing in positively correlated markets. This strategy can detect small divergences and compensate for them as long as markets remain highly correlated. However, if correlations begin to weaken, the correlations should be scrutinised and, if necessary, positions should be split or the approach changed to respond effectively to market changes.