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Correlation Explained

Beginner

Correlations arise as the movement in one asset price can be linked to another. A correlation between two assets can be positive, negative, or not correlated.

What is a correlation?

A correlation is a statistical relationship between two variables. In finance markets, a correlation refers to the link between two assets or trading instruments. How does the movement of one asset impact the movement of a second? This is referred to as a correlation coefficient.

In statistical analysis, correlations can be taken as part of a series of data. This requires the drawing of a line of best fit through a series of dot plots on a graph.

However, when used in the price analysis of two assets, we can chart one price change against another. Using the Correlation technical analysis indicator, price moves are calculated against each other. The indicator then uses an average number of periods (often 21) to smooth the data. The correlation calculation is between -1 and +1.

Positive correlations, negative correlations, or no correlation

Correlations can be:

  • Positive (greater than zero, up to a maximum of +1). When two assets are moving in the same direction, their correlation will be greater than zero. The closer to +1, the stronger the positive correlation. Anything that is > +0.5 is considered a strong correlation. Between zero and +0.2 is a very weak positive correlation, or is considered to have no correlation
  • Negative (less than zero, down to a minimum of -1). When two assets are moving in the opposite direction, their correlation is considered to be negative. The closer to -1, the stronger the negative correlation. Anything < -0.5 is considered to be a strong negative correlation. Between -0.2 and zero is considered to be a very weak negative correlation, or is considered to have no correlation.

Some traditional cross-asset correlations

Some assets will be traditionally correlated to other assets. These correlations are not always consistent and can sometimes turn around. However, over time, the correlations will often run true.

Here is a list of some correlations that will often play out:

Asset 1Asset 2CorrelationRational
    
US Treasury yieldsUSDPositiveHigher US interest rates encourage “hot money” flows into the USD.
US Treasury yieldsUSD/JPYPositiveJapanese bond yields are consistently low as UST yields move around. USD/JPY is strongly linked and is is often the most sensitive major forex pair to changes in US bond yields.
US Treasury yieldsWall StreetNegativeHigher interest rates make it more costly for US corporates to borrow to invest in their business.
USDGoldNegativeA stronger USD makes it more expensive for international buyers of gold.
US Treasury yieldsGoldNegativeGold is a “zero-yielding” asset. If interest rates rise, this increases the opportunity cost of gold.
NASDAQBitcoinPositiveTwo higher-risk investments will move in similar directions as risk appetite swings around

Editor

Richard is an independent market analyst with over 20 years of experience working for brokers in London. Most recently he has worked with Hantec Markets and Infinox, focusing on trading education, ana... Continued

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