Correlation in financial markets / Correlation coefficient in financial markets

Correlation in financial markets / Correlation coefficient in financial markets

Correlation in financial markets / Correlation coefficient in financial markets

One of the most common terms in financial markets, including the forex market or the stock market is the correlation coefficient, which is also widely used. In fact, the difference between a successful trader and an amateur trader is to pay attention to this correlation coefficient in trading. Correlation helps the trader to have as little error as possible in investing and to achieve more optimal investment opportunities. In this article, Zand Traders expresses important points related to correlation in financial markets. Please stay with us until the end of the article.

What is correlation in financial markets?

Correlation or correlation coefficient is a statistical measure that determines how assets move in relation to each other; For example, the correlation coefficient can be obtained for individual securities such as stocks, or the overall market correlation can be measured.

Correlation is measured on a scale of -1 to +1  In this way, a perfect positive correlation between two assets is equal to +1 and a perfect negative correlation is equal to -1; Of course, complete positive or negative correlations are rarely seen; And if two assets have no correlation with each other, the correlation coefficient will be zero.

Correlation in financial markets

Types of correlation in financial markets

As it was said, the types of assets in the financial markets are correlated with each other, and the types of correlation in the financial markets are:

     Commodity/commodity correlation

     Goods / shares correlation

     Currency/commodity pairs correlation

     Currency pairs / currency pairs correlation

In general, the correlation coefficient in financial markets helps traders and investors to cover the risk of transactions. You may ask how? Stay with us in the rest of the article.

The role of correlation for risk management in financial markets

In general, in the financial markets, when the value of stock of several companies goes up or down in harmony with each other, then their correlation coefficient is positive.

On the contrary, when the stock value of one company goes up, the stock value of another company goes down, their correlation is negative.

And when the rise or fall of the stock value of one company has no effect on the stock value of another company, their correlation is zero. This means that the transactions of these two companies have nothing to do with each other.

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Correlation in the stock market

Similarly, in the stock market, you may have seen many times that the growth of one company’s stock has automatically caused the growth of other companies’ stocks, and to know this, you must pay attention to the correlation of those companies.

Therefore, a professional investor, when he is busy with technical analysis, in order to be able to draw charts and indicators accurately, in order to increase the amount of profit and reduce the risk of his transactions, it is necessary to pay attention to the correlation of the stocks you want to trade.

Correlation in the forex market

The main concepts of financial markets are almost the same, and in the forex market you will come across the very important term correlation, and the correlation coefficient plays a very important role in the forex market.

The difference is that in the forex market, currencies of different countries or currency pairs are traded, and currencies play the main role in a transaction.

In fact, the economic conditions, the amount of exports and imports, the social and political conditions of a country determine the value of that country’s currency.

In the forex market, it determines the direction of movement of currency pairs, the correlation coefficient. If the direction of movement of the currency pairs is aligned, their correlation is strong, and on the contrary, if the direction of movement of the two currencies is opposite, the correlation is weak.

Therefore, if for any reason the direction of movement of currency pairs changes, the risk of transactions increases.

The role of correlation for portfolio management

Correlation is often used in portfolio management to measure the degree of diversity in the assets in an investment portfolio.

An investment portfolio is a combination of assets, such as commodities, stocks, or currencies.

Modern portfolio theory (MPT) uses the correlation coefficient of all assets of an investment portfolio to help determine the most efficient capital limit. This concept helps to optimize the expected return against a given level of risk. Including assets that have a low correlation with each other helps reduce the overall risk of a portfolio.

However, correlation can change over time and can only be considered within a certain time frame. For example, two assets that had a high degree of correlation in the past can become uncorrelated in the future and start moving separately. This is one of the problems of MPT theory.

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Correlation and volatility and market volatility

During periods of increased financial market volatility, stock types tend to be more correlated than each other; Even if they are in different departments. International markets can also become highly correlated during times of market volatility. In this case, investors may prefer to include those assets in their portfolio that have a low correlation with stock markets that can help manage their risk.

Unfortunately, correlations between different asset classes and different markets sometimes increase during periods of high volatility. For example, during January 2016, there was a high degree of correlation between the S&P 500 and the price of crude oil, reaching 0.97, which was the largest degree of correlation in the past 26 years, and the stock market was very concerned about continued volatility in oil prices. As oil prices fell, the market was disrupted, with some energy companies defaulting on their debt or eventually being forced to file for bankruptcy.

Final word

In general, choosing assets with low correlation or correlation coefficient can help reduce the risk of your portfolio. Finally, investing in frontier markets (countries whose economies are even less developed and accessible than emerging markets) through exchange-traded funds (ETFs) can be a good way to diversify an equity-based portfolio.

In this article, we tried to introduce you to the concept of correlation in financial markets. Of course, the concept of correlation is much broader than what was mentioned in this article. But the important thing is that a professional trader should consider correlation when choosing the type of stock, the type of currency, and in short what he trades, so that not only his trades are associated with less risk, but also achieve more profit.

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