Correlation, lead/lag, or cross-market correlation is one of the most puzzling topics in the forex market. Many traders use divergences between FX and correlated variables as a single clue of a much bigger puzzle, which also includes analysis of behavioral, technical, macro, and other factors. While cross-market moves are a great trade selection tool, there are many challenges present. Some of the questions involved while trading this way include the following.
What is the cause of these divergences?
Large flows in the foreign exchange market can distort prices which may make a series of variables move one way while the FX does not. For example, let us consider a scenario where the Chinese equities and Australian interest rates both start increasing. As a result, the market would expect the announcement of the Chinese fiscal stimulus package.
Traders will notice that the AUD/USD is still situated in the lows, hovering around the 0.7500 marks and hasn’t moved. A large, non-price sensitive player who is doing something in the AUD/USD market might be responsible for this. For instance, let us consider that an Australian company is purchasing a US company for $1.5 billion, which would require them to buy USD and sell AUD to complete the transaction. In such a situation, they may not care about how Chinese stocks or the Australian interest rates behave and can have a certain budgeted FX rate. In such a case, they might leave an order with their bank to buy 1.5 Billion USD by selling 2 Billion USD at 0.7500 or more. Since this is a big order, the selling will affect the AUD for some time, no matter what is going on with the prices of other assets.
Traders who are astute would purchase AUD after seeing other proxy assets rising. However, the price will not move until the 2 billion AUD sell order is gone. The AUD sell order will eventually get chipped away if the China story continues to look good and will subsequently jump higher towards a new equilibrium when the order is finally filled.
When comparing with short-term speculators, FX flows and orders are executed by players who trade on a different time horizon and use a completely different set of variables. This is the primary cause of the frequent dislocations and divergences between FX and correlated variables.
Isn’t it possible that the currency isn’t wrong and the variable is?
The above question generally applies in cases where traders are running a single variable against any currency pair. For instance, if the price of copper is going higher but the AUD/USD hasn’t moved. In such scenarios, traders should understand whether the AUD/USD is wrong or if the move is a result of a non-price sensitive flow into copper.
Traders should consider two things in such scenarios. The first one involves all the multiple variables pointing in one direction. Traders will have a better trade in this case, as it is highly likely that the FX is wrong.
In the second one, the variable with the most momentum wins. For instance, let’s say that copper breaks out to the topside after trading in a quiet range alongside AUD/USD. Traders should favor the direction of copper, rather than the AUD/USD. In such cases, they should long the AUD, with the expectation that it will eventually catch up with copper.
However, traders shouldn’t do anything if the AUD breaks higher while copper continues to rest near the bottom of the range. This is because one should look for divergences rather than the momentum which AUD possesses in this case. They should look for divergences where the correlated variables are moving with momentum in a specified direction, while the FX does nothing. Situations that involve one variable rallying hard while the FX is selling off aggressively, can get confusing and traders should not touch them.
Why doesn’t the trader do a relative value trade instead of trading one side via the FX?
A relative value trade involves buying the low one and selling the high one. It involves a lot of subtleties, including risk management, position-sizing, when to stop out or add as divergence grows, etc. Relative value trading and directional FX trading are different, as the latter involves the trader putting on some concentrated and levered trades to produce directional profits.
Doesn’t the direction of the divergence and magnitude of the move depend on how the chart is scaled?
Traders need to be careful about how they scale their charts as this definitely has an effect. They can use hourly charts and overlays and scale them between 21 and 42 days’ worth of data. Traders who use a daily chart and look at five years’ worth of data can get very different results.
Traders should thus try to be consistent with their choice of scales. Failure to do so will make them susceptible to confirmation bias as they would then be scaling their charts to different dimensions to find the answer they desire. The scaling should be according to the trader’s time horizon. If one trades short-term, they should look at three months of day or less.
Both day traders and short-term traders use 10 minutes, 30 minutes, or hourly charts for the last three months. While any time period less than a month gets noisy on the chart, anything more makes it too difficult to see short-term dislocations. Divergence appearing in all scales of a chart is an ideal scenario but occurs rarely.
Traders can scale their charts by capturing a specific regime period. For instance, let’s say that the market remains indifferent to Portuguese yields. If any news comes out regarding Portugal defaulting on its debt, the EUR/USD will start trading tick to tick with those yields. On September 14th, if a trader wants to look at Portuguese yields which began on August 1, he/she should scale the chart from August 1 to September 14th.
Divergence and the implied fair value which the chart suggests are not definitive. When traders overlay a currency pair with a correlated variable, they are merely getting a rough sense of how the two relate. However, it’s not just pure math, but a combination of art and science. Traders should rely on other types of analysis rather than just lead/lag.
What are the other ways to trade cross-market correlations?
Cross market analysis is great for forecasting equities.
Traders can either:
- Use leaders to forecast the index, such as using a stock like Apple over the NASDAQ.
- Use Sub-indices to predict moves in the main index
Adding lead/lag analysis to a trade’s toolbox can help them to find new and interesting trading ideas by combining it with other techniques.