How does work and determine the correlation
Pair trading practices profit from fluctuations in the spread of interconnected securities. The degree of correlation is estimated by the correlation coefficient, and the spread here is the difference in prices of two or more assets. If the financial instruments are sufficiently synchronous, then any changes in the correlation may be accompanied by a return to the average trend of the pair cointegration. This feature of correlated pairs gives interesting opportunities for making profit.
Simple words: Imagine a person walking a dog. They move along the same route, even if they are distant from each other. The dog leash limits the distance between them, so they are likely to return home together. In paired trading, correlation is the single route, and cointegration is the leash.
Pair trading is equally suitable for currency and stock markets, read more about it here. It is the most attractive type of arbitration for minority shareholders due to low capital requirements, low risks and high returns. For those who are tired of being dependent on volatile trends, it is worth a little more effort to master this strategy. The first step towards pair trading is to understand how the correlation works.
How does the correlation work?
The correlation coefficient measures the degree to which the values of one variable are related to those of the other. The values of the coefficient vary from -1 to +1 where:
-1: negative correlation. It exists when two instruments move in opposite directions the so-called mirror chart. A vivid example is the currency pairs EUR/USD and USD/CHF.
0: There is no correlation. Price movements are completely random.
+1: positive correlation. It exists if two financial instruments move in the same direction. An example is Silver and Gold charts. Their correlation coefficient on the Daily timeframe is 0.9.
Traders are looking for assets with a high degree of correlation in order to profit when prices go beyond the statistical norm. The parameter 0.8 and above is often used as a benchmark to indicate a strong correlation between the instruments, while the correlation of less than 0.5 is considered weak.
Both positive and negative results are taken into account, so both +0.8 and -0.8 are high correlations. In the first case, the assets move unidirectionally, and in the second case mirror. Both options are suitable for trading, but it is important to consider the following factors. When working with a positive correlation, trading is multi-directional that is, one asset is bought and the other is sold. And when working with the negative correlation, trade is carried out in the same direction two deals in shorts or longitudinal ones are opened simultaneously.
How to determine the correlation
Specific mathematical calculations of the correlation coefficient are quite complex and go beyond the scope of this manual. However, traders have several options for determining its value:
Specialized software or technical indicators. It can be applied to two securities, automatically performing mathematical functions and displaying results on a price chart.
Self-calculating data in Excel or Google Docs. Ideally, if the quote table values are automatically uploaded online. Otherwise, you will have to prescribe them manually. The next steps are to use the built-in CORREL function to perform calculations and display the resulting chart in the table.
Free service for calculation of pair correlation from megatrader.org. Here are available coefficients for currencies Forex, stocks, metals, indices and other financial instruments. In addition, for each pair a spread chart is drawn.
After determining the correlation coefficients, the results can be used as a filter to find the pairs that show the highest trading potential.