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How To Trade Using a Correlation Strategy

Below is an explanation of Correlation Trading and how it works.

If you'd like to see a live demonstration, sign up for the free webinar happening tomorrow (Wednesday, October 28):

Sign up here: http://www.traderinterviews.com/links/TradingWebinar1

While correlations will tell you that a move is about to occur, correlation alone doesn’t tell you which pair is moving or the direction it will be moving in.

In other words, you know you need to put on a trade, but you don’t know which pair to trade or whether you need to buy or sell short. This massive limitation in correlation trading has stifled traders for years, which is why so few traders use correlations despite its obvious benefits.

Of the handful of traders who did trade with correlations, most just used it as a filter to increase the accuracy of an already-profitable system.

Well I for one wasn’t willing to stop there…

 

You see, as a full-time trader, researcher and system developer, I know that identifying PREDICTABLE VOLATILITY is half the battle. Determining entry and exit points is simply a matter of testing and a whole lot of trial and error.

It took the better part of 12 months, but eventually my team and I researched, developed and tested 82 different strategies for capitalizing on correlation trades. When the dust settled we were left with only 8 that made cut…and because you’re a Trader’s Blog reader, I am now going to share one of my favorites with you.

Follow The Leader

The strategy is called “Follow the Leader”, and while it’s one of the simplest of the 8 strategies my team and I developed, it’s no less important. Honestly I’m giving you this method because I really want you to attend my Correlation Webinar that is on Wednesday!

The “Follow the Leader” Correlation Trade like all correlation trades, “Follow the Leader” waits until two correlated pairs go “out of whack”, and then quickly capitalizes on the opportunity to scalp some quick pips out of the market.

Here’s how it works…

For this system I like to trade the EUR/USD along with the GBP/USD. These pairs are positively correlated, so as expected they are more or less moving parallel to one another (as seen on chart below). But when we’re trading with correlation, we’re not only looking at direction…we’re also looking at the RANGE.

“Range”: The difference between the high and the low prices during a specified period of time.

We know, for example, that the GBP/USD normally has a much larger range than the EUR/USD (NOTE: I don’t have the time right now to go into why the range of the GBP/USD is larger, but if you look at the two charts side-by-side you’ll be able to see with the naked eye what I’m talking about.). In other words, while these correlated pairs will generally move in the same direction, the GBP/USD should have lower valleys and higher peaks than the EUR/USD. So, when we see that the range of the GBP/USD is lagging behind the range of the EUR/USD for one bar (see chart), we have a potential trade setup. Once the “range lag” is 20 pips or greater, we take the trade with the expectation that the GBP/USD will make up the “gap”, and overtake the range of the EUR/USD within a few bars.

Remember, we know this is an extremely high probability trade, because “Fundamental Law” dictates that the pairs MUST remain in correlation, so therefore we know that they will eventually “snap back”. Like I said, it’s a simple strategy, but because it’s backed by market fundamentals it’s one of the most accurate (and profitable) intra-day strategies I’ve ever traded.

OK, let’s check out the chart as mentioned above:


Right now the range of the GBP/USD is lagging the EUR/USD by 8 pips. That’s enough of a lag to take notice, but it’s not enough to take the trade yet.

Remember, I like to see at least a 20 pip lag before I take the trade, so I’ll watch it for another bar and see what happens…

When the second bar closes, the range is now lagging by 15 pips. It’s still not enough for me to take the trade yet, but the fact that the range lag still hasn’t corrected itself (and is actually growing wider) has me very excited.

I’ll wait and watch it for one more bar and see if the “range lag” or “crack” widens enough for me to take the trade…

The third bar has closed, and the “range lag” has now widened to 24 pips. That’s greater than the 20 pip minimum I need, so I’m going to take this trade and go long on the GBP/USD.

My expectation is that the GBP/USD will at a bare minimum make up the 24 pip “range lag” or “crack”…and possibly even go beyond that since historically the range of the GBP/USD is supposed to be LARGER than the EUR/USD

And again, when we’re trading with correlation and something goes “wrong” (as is the case with this “range lag”), that usually means there’s a profit opportunity just around the corner. :)

Now that we’re in this trade, let’s watch it and see what happens next…

As you can see, the very next bar the GBP/USD made up the “range lag” and returned to
“normal” just as we expected it to. We then exit the trade at the end of the bar and
pocket the 24 pips.

So there you have it…the “Follow the Leader” strategy!

So to recap, all you need to do is:
1) Watch these 2 pairs simultaneously.
2) Track the movement of both pairs at the close of each bar.
3) Once you see one of the pairs begin to pull away, pay attention because you are now looking at a potential trade setup.
4) Calculate the “range lag” or “crack” and when it exceeds 20 pips, you’re ready to pull the trigger, and you know what your target will be, as it will be always be about equal to the “range-lag”!

I’m confident that this one strategy alone will make you a more confident, accurate and profitable trader, as these trades are ultra high probability trades to take, and I LOVE when they set up…

If you'd like to see a live demonstration, sign up for the free webinar happening tomorrow (Wednesday, October 28):

Sign up here: http://www.traderinterviews.com/links/TradingWebinar1