Forex Trading Money Making | Correlation and prediction | Technical Analysis #2

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In our last post, we talked about risk and money management, if you missed it make sure to check it out!

The correlation coefficient has a limited ability to predict returns for individual stocks in the stock market. Nevertheless, statistical analysis may have significance in predicting the degree to which two stocks shift in relation to each other since the correlation coefficient is a calculation of the relationship between how two stocks shift in conjunction and the frequency of that relationship.

Although the correlation coefficient might not be able to predict potential market returns, the concept is valuable for assessing (and mitigating) risk, since it is a core component in modern portfolio theory ( MPT), which seeks to assess an effective frontier. The successful frontier, in particular, offers a curved relationship between a potential return on a portfolio mix of assets versus a defined amount of risk on that asset mix.

The coefficient of correlation is measured on a scale of -1 to 1 A correlation coefficient of 1 implies a complete positive correlation between two asset values, indicating that the markets are both going the same direction for the same rate. A -1 coefficient indicates a perfect negative correlation, meaning stocks have always moved in the opposite direction, historically. When two stocks have a coefficient of correlation of 0, this implies that there is no connection and thus no link between stocks. It is unusual to have either a positive or a negative correlation to perfect.

The correlation coefficient can be used by traders to pick assets with negative correlations for use in their portfolios. The correlation coefficient calculation takes the covariance of the two variables in question, as well as the standard deviation of each variable.

Thus standard deviation from its average is a measure of data dispersion, covariance is a measure of how two variables shift together. Through dividing covariance through the sum of the two standard deviations, the correlation coefficient may be determined and the degree to which assets are expected to shift in parallel within a portfolio.

The correlation coefficient is essentially a linear regression (statistical analysis) carried out on the returns of each stock against the other. If mapped graphically, an upward sloping line would show a positive correlation. A negative correlation would show a line sloping downwards. Whereas the coefficient of correlation is a calculation of the historical relationship between two assets, it may also provide a reference to the potential relationship between the assets.

The correlation between two investments is therefore dynamic and subject to alter. The correlation will change, especially in periods of higher volatility, just as portfolio risk increases. As such, because of the fact that correlations remain constant, MPT may have weaknesses in its ability to protect against uncertainties during times of high volatility. MPT's limitations also limit the correlation coefficient 's predictive power. Pairing MPT with the use of correlation and a trading signal can be a very powerful combination that could yield a very profitable trade. The services of trading signals providers such as Tools Trade can help immensely, we did a review of them in one of our previous posts so make sure you check it out as well!

In modern portfolio theory correlation is used to include diversified assets that can help reduce a portfolio's overall risk. However, one of MPT 's key critiques is that it believes the association between assets over time is static. In reality, correlations frequently shift, particularly during periods of increased volatility. In short, while correlation has some predictive value, the use of the method has limitations, and I suggest you use it only to supplement your technical analysis, but not as a basic method.

That is everything for today, feel free to check out the video below on this topic, stay safe and I will see you soon with more tips and tricks, trading signals and guidelines for Forex trading!

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