Double Trouble: Correlated Markets Wreck Trades – Here’s What to Do

Hello everyone, it’s Dale here, and in this video, I’d like to play a recording of our live trading room, which we had on Monday with members of the Funded Trader Academy. Monday was quite slow on trades, so we had some time to talk about correlations, since the members were interested in that. I thought this would be beneficial to you because correlation is really a topic that affects everyone who trades with more than one trading instrument, right? So, if you trade with more than one instrument, correlation does affect you.

In this recording, you will learn what correlation is, how to read the correlation table, and how to effectively use it in your trading. You will also learn how to avoid unnecessary risk by taking too many heavily correlated trades—all explained, as we usually do, in a very practical way. So here is the video—enjoy!

This is a correlation table, and it shows how two currencies—how their charts—move the same way. If the correlation is, let’s say… okay, let’s take a look at this table here and set an example. So, for example, let’s check out the correlation between EUR/CAD and EUR/USD. We always compare two symbols, right? The correlation between those two is 95. Correlation is always between -100 and +100. Since the correlation between EUR/CAD and EUR/USD is 95, that means they are heavily correlated—that they move almost the same way. So, if EUR/CAD is moving like this, then EUR/USD will look like this. This is positive correlation. If it’s 95, they move like 95% the same.

What you take from this is, for example, when you are trading those two pairs, and let’s say you enter long on both—long on EUR/CAD and long on EUR/USD—then you can imagine it like on this chart I drew: you went long on EUR/CAD and long on EUR/USD. In this case, both those positions would be winning, but you’ve exposed yourself to bigger risk, because they correlate. If one starts to go down, then the other will likely drop as well. In this scenario, you’re gaining double because both pairs went upwards—that’s the better scenario. But in the scenario where price drops, you’re losing double. That’s why correlation matters. You should always keep that in the back of your head.

If you enter two trades, it’s more or less fine if they are correlated, but if you enter, for example, three—my personal pain point is three—then the risk increases. Let’s say you enter three heavily correlated trades: EUR/CAD, EUR/USD, and GBP/USD, which has a 93 correlation with EUR/USD. That means another heavily correlated instrument. In this case, if the price goes up, you’re gaining triple—that’s great. But if things go wrong, all three pairs are likely to drop, and you’re losing triple—and that’s terrible. This is why you want to use the correlation table and at least be aware of the pairs with the highest correlation.

I, for example, focus mostly on trading the majors, and I don’t even need to look at the table. I know that, for example, EUR/USD and USD/CHF have a strong negative correlation of -95. That means if EUR/USD goes up, USD/CHF goes down. So, if I enter a long trade on EUR/USD and a short on USD/CHF, it is very likely that both those trades will have the same result. Either it’s going to be two winners or two losers—it’s very likely because they move in opposite ways. So I need to be careful about this. That’s why I need to know about correlation.

Another example of heavily correlated pairs is AUD/USD and USD/CAD. If you check AUD/USD and USD/CAD—where is it here—it’s around -73. It’s not as strong as EUR/USD and USD/CHF, but still, those two move quite similarly in opposite directions. If AUD/USD goes like this, then USD/CAD will go like this.

Sometimes, the correlation changes over time. Some pairs stay heavily correlated, but over time, especially during macro news, the correlation can become stronger. Let’s say this week we have the FOMC. The correlation could get stronger, especially during the macro news. For example, if the FOMC causes the USD to strengthen—just for the sake of this example—then during that event, when the dollar starts to strengthen, all the majors will be affected.

So, if the USD strengthens, EUR/USD will go down, GBP/USD will also go down, USD/JPY will go up, USD/CHF will also go up. I won’t list all the majors here, but the point is the USD will be the main force behind all those moves. All those will start to move—some down, some up—and this will be caused just by the strengthening of the USD. One currency strengthening affects everything.

That’s why correlation during macro news plays such a strong role, and correlation usually gets stronger during those times. Because one pair moves, and the other pairs may not even be affected that much—but because the dollar moves, everything else moves. Everything becomes heavily correlated. That’s why traders who trade during macro news, and open multiple positions, either get huge winners or blow up their accounts—because everything starts to correlate, and that’s where things get very risky.

Another thing I wanted to say about correlation is about the table itself. You can switch between different time frames. The higher the time frame, the more you can rely on what the table is telling you. If you go to the 5-minute time frame, for example, the table will look different. Let’s compare EUR/USD with USD/CHF. It’s -69. Now let’s switch to the 15-minute—92. Hourly—oh wow, 8. That’s weird. 4-hour—minus 50. Daily—minus 95.

What I wanted to say is: the faster the time frame, the more distorted the correlation can be. Well, not distorted, but it doesn’t reflect the big picture. You want to focus on the general rule of how those pairs correlate. On the 5-minute time frame, EUR/USD may move independently of USD/CHF. But if you go to the daily chart, it more accurately reflects the general behavior. So I wouldn’t pay too much attention to the faster time frames. Just remember the general correlations for the pairs you trade.

The best case is when you are trading pairs that are not correlated—ideally zero, but it’s never exactly zero. So let’s say a sweet spot is from -20 to +20. That’s ideal. When you have multiple trades that are not correlated, you don’t expose yourself to as much risk as when trading heavily correlated pairs. That’s the ideal scenario—but it rarely happens.

Back in university, we did a lot of stock investing and learned about portfolio management. One key idea was that for long-term investments, you always want low correlation between the assets in your portfolio. The ideal correlation is zero—you never get there, but the lower the correlation, the lower the risk. That’s what they taught us, and it’s true.

Here’s a question: do you hedge with correlated pairs while trading, or do you look for uncorrelated ones? I don’t hedge, and I’m not really looking for uncorrelated trades either. But if I’m entering multiple trades, I want to know if they are correlated. If they are, I want to lower my risk.

So, let’s say I enter three trades: long on EUR/USD, long on GBP/USD, and short on USD/JPY. What happens if the USD starts to strengthen? The first trade (EUR/USD) goes down—losing money. The second trade (GBP/USD) also goes down—more losses. And the third one (short on USD/JPY)—also a loss. So, I’m losing money on all three trades.

If I see that I’m about to enter three very similar trades—heavily correlated—I want to lower my risk. The way I do it is I use 50% of my normal position size. If I normally trade one lot, I use half a lot. I still take the trades, but with smaller positions. Because the outcome of all those trades is likely to be the same. If all of them are losers, it’s not as bad if you used half size. That’s how you control risk. So it’s not about avoiding correlated trades—it’s about managing your risk when you take them.

Just go to that correlation table—you can filter it to only show the trading pairs you are interested in. You can do it here, and here. If you only want to see the majors, do it like this. The table gets smaller, and now we only have the majors. Then we can look at the biggest correlations between the majors. As you can see, some of the strongest are between EUR/USD, GBP/USD, and USD/CAD. Also, there’s good correlation between USD/JPY and USD/CAD (only 14—that’s fantastic), and USD/CHF and USD/CAD (correlation of 1—that’s also great). The strongest correlations we talked about are here—93, -95, -91—so you want to be aware of that.

Okay, let me go to that question: what’s your typical way of entering the trade when the price is approaching your level? Let’s have three charts: EUR/USD, GBP/USD, and USD/CHF. Say I have support on EUR/USD, support on GBP/USD, and resistance on USD/CHF. Price is dropping toward support on EUR/USD, dropping toward support on GBP/USD, and rising toward resistance on USD/CHF. When I see that all three levels are about to get hit, that’s when I use smaller positions. If I normally trade 10 lots, I reduce to 5 on each trade—to control the risk.

Yeah, sometimes it’s annoying. One trade might turn just before hitting the level, another one hits it, and the third hits it too—so you might miss one. But still, the first thing you should think about is reducing risk. Even if one trade misses, it was still a smart decision to lower your risk. The worst case is losing three full-sized, heavily correlated trades. I use limit orders most of the time, but I’m always at the computer, so I can adjust quickly if needed.

Does that make sense? Is it clear now, or is there anything else you’d like to ask about correlation? When I adjust orders, it’s because of correlation. If I see trades are heavily correlated, I reduce my position size. For example, EUR/USD and GBP/USD have a correlation of 93. USD/CHF and EUR/USD have a correlation of -95. So if the USD starts to move, it will affect all three trades, and the outcome will likely be very similar.

Alright, so that was that. I hope you liked it. If you’d like to join us and trade live every day in the live trading room, then I recommend visiting my website at trader-dale.com. If you click the FTA button, it will take you to the Funded Trader Academy page. There, you can book a one-on-one meeting with us, and we’ll walk you through the service. Then you can decide whether or not it’s right for you.

Alright, that’s it. Thanks for watching the video, and I’ll see you next time. Until then, happy trading!