How to Use Diversification and Correlation in Your Trading

Diversification is a key point which any trader or investor needs to understand if they’re trading more than one instrument concurrently. It can be both a strength and a weakness as a properly diversified portfolio has the potential to help smooth out some of the peaks and troughs seen in the market on a day to day basis, but conversely, trading a number of closely correlated instruments has the potential to exaggerate any gains or losses.

Correlation coefficients

The most important point to understand is something called a correlation coefficient. It’s a number between +1 and -1 that indicates the relationship in terms of strength and direction between any two factors – in this case, asset prices. A reading of +1 would mean the two prices are perfectly correlated, with an increase in asset X translating into an equivalent increase in asset Y. Conversely, a reading of -1 means there’s inverse correlation, so an increase in asset X translates into an equivalent decrease in asset Y. You can easily calculate your own correlation coefficients between any two prices using the CORREL function in popular spreadsheet packages such as Microsoft Excel or Google Docs. Alternatively, correlation coefficients for major currencies can be found here.

A good example of high correlation

Over the long term, EUR/USD and GBP/USD typically move very much in tandem. Granted there have been political factors in play of late - most notably Brexit - which have served to break this relationship, but look at the following chart.

 

Chart Source: Author

 

This shows the performance of EUR/USD and GBP/USD over the last 15 years. Note patterns such as the very similar sell-off observed since the start of 2018 as the US started to hike interest rates. Similarly, the gains coming off the back of the credit crisis in 2009 left prices moving higher. Overall, it’s clear that the two currency pairs largely move in tandem.

A good example of inverse correlation

The flipside here is that asset prices can sometimes be inversely correlated. That’s the situation when the first asset appreciates, the second depreciates. Such situations can be common in currency markets when the base currency isn’t always the same. So, EUR/USD and USD/CHF are often cited as having a high inverse correlation, but that’s no real surprise as in one the US Dollar is the quoted currency and in the other it’s the base currency. The inverse correlation here was even more marked back when the Swiss National Bank was pegging the value of the Swiss Franc to the Euro.

But such patterns aren’t unique to currency markets alone. The chart below shows the performance of the FTSE100 against GBP/USD.

 

Chart Source: Author

 

A shorter time frame has been used here for clarity, given the constant appreciation of the FTSE-100 over multiple years. However, specifically look at what happened in June 2016 off the back of the Brexit vote. The Pound slumped but the FTSE-100 soared. Again, this pattern repeats – take the GBP sell off in April 2018 and compare with the jump in the FTSE-100. As an aside, there’s a very good reason behind this. The FTSE-100 has a lot of companies in there who make profits in US Dollars, yet the shares are priced in Sterling. That means a weaker Pound amplifies foreign currency profits, driving share valuations higher.

So why does this matter?

If you’re trading one instrument at a time, there’s no need to be mindful of correlation, but as was noted at the outset, once you start diversifying your holdings, interesting things can start happening to your portfolio. Diversify into a long GBP/USD and a long UK-100 (FTSE-100) and history shows us that as one of those assets appreciates, any gains could well be eradicated by losses on the other side of your portfolio. Conversely, a short GBP/USD and a long UK-100 position held over events such as the Brexit vote outcome would have resulted in gains for both trades; holding the same in early 2018 would have resulted in losses on both trades.

The takeaway

Diversifying your holdings across instruments with high correlation coefficients presents the ability to see your trading outcomes being amplified and as such is likely to appeal to many day traders. Equally however, understanding that level of correlation may help in improving your trading strategy and understanding how much risk you are exposing yourself to at any one time.

 

The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.

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