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Market Correlations To Improve Your Trade Selection

The following is an excerpt from Risk Tolerance Threshold Theory, by Jay Norris & Teresa Bell

While it is important to know the collective pattern of an individual market, it's even more important to know how the majority of major markets or economies are collectively aligned. Before you decide which market to trade you need to know the importance of how markets relate to each other. Never make an analytic decision based on behavior in just one market. The direction of the impulse moves that determine the scales in all financial markets are influenced by the patterns of the more heavily traded asset class markets, i.e.: alpha markets, which reflect current investment conditions and the global business cycle. The patterns of low yielding currency pairs, where the countries are all implementing similar Keynesian policies, or commodities that can be substituted, can be compared to planets taking their cue from the larger stars, such as the S&P 500 with its blue-chip dividends and huge global footprint, or the Australian Dollar or AUDJPY with their hefty, margined yields.

Perhaps you have heard that markets spend more time in sideways, counter-trending markets that not? That is true. Markets spend over 70% of time doing very little. For the majority of time markets bump along in apparent haphazard direction with stocks going down, and Aussie going up, and Euro going sideways, or vice versa. When we see this directionless state for the financial markets we know that both collectively and individually the markets are counter-trending. The top panel in Figure 5 highlights this behavior. We marked out those short periods of time when the markets were aligned and moving in the same direction. It was less than 30% of the time. On the chart below, which is the EURUSD, we see that those times when prices were not aligned on the top panel that price bumped along in lackluster sideways trade. Those times when markets did align however, that is asset class markets such as blue-chip stocks, carry currencies, and USDJPY started all pulling together, we saw trending behavior. When price correlations are strongest is when markets exhibit impulsive, trending behavior; when correlations are faltering markets produce counter-trending price action with the different market groups such as blue-chip stocks and carry currencies moving counter-to each other.

Figure 5. Trending Moves Occur When the Majority of Major Markets are Aligned

In the graphs in Figure 5 we are making the point that the largest "trend" moves on the bottom chart, EURUSD, occurred when the 5 markets on the top chart are aligned. This is a normal dynamic. When the 5 markets in the top chart are bumping along counter-trend to each other - which is the majority of the time, the euro, on the bottom panel shows sideways directionless trade. Once the 5 markets align - the macro picture --and move in the same direction, trending price action occurs for the individual market - the micro picture.

When you see currencies and stocks trading counter to each other you need to be cautious because these markets are more liable to see directionless sideways trade. When all the markets are aligned however - carry pairs, stock indices, ETF's - we are more likely to see trending price action, which for trend traders is the best time to go to work.

Jay Norris is the author of The Secret to Trading: Risk Tolerance Threshold Theory. To see Jay point out trade set-ups and signals in live markets on the London/U.S. overlap go to: Live Market Analysis

Trading involves risk of loss and is not suitable for all investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.