Definition of Correlation Trading: Trading currencies which tend to move in the same direction (Positive Correlation) or in the opposite direction (Negative Correlation).
The appeal of this particular style of trading was that by trading pairs of currencies that had a strong correlation to one another, you could diversify your overall position while at the same time be shielded from risk. The risk would be spread across two pairs that almost always moved the same way or if the currencies moved in the opposing directions, your risk would be diminished in this way as well.
In 2009 the GBPUSD and the EURUSD had a strong positive correlation coefficient of over +.90, which meant that when the EURUSD went up, the GBPUSD almost always went up also. Two opposite moving currency pairs were the EURUSD and the USDCHF, which had a high coefficient of over -.90, which meant that they moved inversely almost all the time - when one pair went up, the other pair went down. A 1.0 correlation coefficient meant that the pairs moved together in a perfect correlation. So .90 was very very high.
We were part of a trading room where our current mentor called out trades and we would follow his advice. Again, curiously, this guy was an expat living in Portugal, supposedly for tax purposes since he was making such huge amounts of money.
We used a strategy of hedging one currency pair with another. He would check to see what the correlation coefficient was of the pairs he was interested in and base his choices on that. Sometimes confidence would be high, so we would double up by posting trades on the same parallel-moving currency pairs. There were all sorts of combinations that he recommended for the Euro, Swissie and Pound, mixing and blending positions like a chemist. If we went long the EURUSD we would also go long the USDCHF. Since they moved in opposite directions, if the EURUSD was losing, then the other pair would be in profit or vice versa. So whatever loss we saw on one pair was made up for by the profit on the other pair.
It was a complex strategy balancing the different positions, but he assured us that he would explain his methodology well enough over the coming months that we would be able to confidently trade it ourselves. Meanwhile, we just followed his trade calls because we were making really good money with him. And at the same time we continued asking all the questions we could. He told us that other people in his group, who had been with him for many years, were up alone this year over 300% and the gain he reported for their prior year left us salivating even more.
A few weeks later he had a family wedding to attend in a nearby town where there was no internet available. It just happened to be right when the EURUSD and the USDCHF fell out of correlation. We were sitting there with open positions on both pairs and their relative entry prices spread to over 700 pips difference. All the while, our mentor was drinking, dancing and celebrating, oblivious to our futile attempts to reach him. Many in our trade room suffered margin calls and were in shock over the demise of their accounts. But thankfully by this point, we had started creating our own position size calculators and had modulated our risk so that we would be able to survive this kind of catastrophe.
When our mentor finally returned, he didn't seem that concerned and assured us that over the next few months we could keep our positions open and they would come back into correlation and we would recover. We wanted to diminish that drawdown so we decided to trust him and hang in there. But after 3 months of hoping and praying and not seeing the return of the correlation, we closed the trades, bailing on the positions and on him.
Again we received another lesson in trusting that something that once worked in the forex market would be something that would continue to work. Changes in the economic balance, interest rates and government policies caused the currency pairs to stop behaving in tandem and our newest strategy was no longer in vogue. To be continued...
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