Developing a System #2 (Entry system for hedging correlated pairs)

How about my post???

Insider

Hello,

Can one use correlation divergence to trade two pairs against each other?

EX. EUR/USD goes up while GBP/USD goes down. They normally go the same way. Ok, so when you this scenario, you sell the first and but the second. But if you do that, you "hope" that the divergence in the correlation will only go stronger. There is a little bit of a paradox in this, don t you think? You want the price of both pairs to go more in tune with each other and, on the other hand, you want the correlation to push harder in negative territory, at least for the short term.

Hope this makes sense. I know this system is used but I am not sure of the exact method. For instance what is optimal entry and exit...

Thanks and regards,

Insider

Hi scott,
Can you please share correl indicator please

Like Scott said.. you need to use it with another indicator. I use this method very successfully ;)

best of luck

Hi Ben,

The indicator hasn't been shared yet by the author.
Here is one I found on the forums:
PairDifference.mq4

Kind regards,
Edward

please can i have indicators that are in this stratery?

ben messkin

The direction of change in correlation is what you are after, isn't it? CORREL will either be going up or down regardless of the period.

EURCHF and USDJPY are hardly positively correlated (it was for only short moments). If you based your strategy on truth of the moment or impression that these two pairs are positively correlated, then your trade would not be very successful. I wonder if you purposely set up your trade on pair randomness (i.e., correlation between 0.50 and -0.50) in which case you would still lose money when the pairs are moving in into the +/-0.80 region. I also checked the correlation between GBPUSD*EURUSD and EURJPY*GBPJPY as per Diablo's suggestion but they are not much correlated either (see screenshots). You can see that the JPY-relatives are quite different from the AUD-relatives.

Scott

Sure Edward, will upload it once I finish the quick user guide.

Could you share the indicator with us?

Regards,
Edward

Sorry forgot to include links to the CORREL indicator images:

Correlation (or CORREL) between two currency pairs is not static, even for some seemingly highly correlated pairs (e.g., GBPUSD*EURUSD, AUDUSD*XAUUSD). Analysts who say a correlation of > 0.90 means the two pairs will move in the same direction 90% of the time can be misleading. What they often didn't say is the number of bars you need to use to calculate the correlation.

CORREL(20), CORREL(50), CORREL(100), and CORREL(200) would give you very different information. If you use the long-period CORREL you mask the short-term reversals. If you use too short a period, the indicator would look almost unreadable. Nevertheless you always need to use at least two periods (two indicator windows), such as CORREL(20) and CORREL(100), in order to figure out the direction of the correlation shift.

Remember correlation can shift, cross and diverge over time, much like the behavior of a price MA. When the correlation of two pairs diverges (i.e., correlation drops out of the region between +/-0.80 and +/-1.00), it would be hard to guess when they would merge again. This is where and when you could sustain losses even when you are hedging.

Also, currency pair correlations presented in matrix/table on FX forums (such as http://www.mataf.net/en/tools/correlation-table) only give traders a snapshot for that moment. This can be really dangerous because traders unfamiliar with correlation may get the impression that the correlation between two pairs is somewhat constant and varies slightly sometimes, which is far from the truth. When I sometimes heard analysts say in news headline like "AUDUSD traded higher on commodity (gold) rally", I often went back to look at my CORREL indicator to check if they really had that right. Sometimes I had the reason not to believe them.

I believe correlation should be used with other indicators in order to give you an edge. Right now I only use CORREL to confirm the news effect or fundamentals from one pair to the other when one pair does not have much news on the newswire. For example, if the more volatile (or leading) pair breaks out, chances are the other positively correlated pair is likely to breach similar resistance or support levels. Correlation is about exploiting time lag to make predictions about the other pairs.

Sorry to drop this bombshell, but usdjpy and eurchf are not positively correlated. try gbpusd and eurusd, or eurjpy and gbpjpy for example. Diablo

In pairs trading one often using normalized deviation. Below is quota from "The handbook of pairs trading" by Douglas S.Erhman. BTW this is good book about subject You interested in.

Regards

Andrew

"
NORMALIZING DIVERGENCE
This technique is used in any mean reversion strategy and allows the
trader to compare divergence to a normalized distribution. This provides
cleaner data with which to analyze any given trade. The technique is commonly used to compare a stock’s price with its moving average, the assumption being that the stock price will tend to oscillate around its moving
average. [...]

This process is referred to as a Z transformation and is obtained by taking
the difference between the price of Microsoft and its 10-day moving average,
subtracting the average of the difference, and dividing by the
standard deviation of this difference. As can be seen from the chart, this
normalized deviation oscillates around zero fairly symmetrically. This
relationship could be exploited by trading on the assumption that at a
given level of divergence, there is a high probability that the deviation
will revert to zero."