Correlation trading involves trading two securities that usually move in tandem and one of the securities is bought or sold short when the correlation factor breaks down. The idea behind the trade is the left-behind security of the pair will move to bring the correlation back in line. Examples of pairs that may correlate include the Australian dollar and the price of gold or the price of oil and the price of gasoline. The average true range indicator can be used to determine which of the securities in the selected correlation pair is lagging the other.
1. Set up price charts for the two securities you want to correlation trade. The charts should use the same time frame for bars or candles, such as one hour, four hours or daily. Add the average true range indicator -- ATR -- from the choices of technical indicators in your charting software. You want to be able to view the two charts side by side on your computer screen.
2. Adjust the the parameters of the ATR indicator to show a quicker response to value changes between the correlation pair. The standard setting for ATR is 14. Initially set the indicator to 7 time units and adjust from there. The ATR indicator will show in a panel below the price graphs of the selected securities. A higher ATR indicates increased volatility and a lower value shows decreasing volatility.
3. Watch the ATR values for a divergence between the correlation pair. If one security is showing increasing volatility due to a higher ATR and the other has a level or declining ATR, the correlation is breaking down. The expectation is the security with the lagging ATR will soon exhibit increasing volatility to catch up with the other security.
4. Buy or sell short the security with the lagging ATR in the direction of the correlation pair trend. If the two securities are trending upward, the trend would be opened with a buy order. If the trend is down, open the trade with a sell order.
5. Close the trade when the two securities have moved back into correlation as indicated by ATR graphs with similar profiles.
- This correlation trade strategy is designed to determine which of the securities pair will give the largest value move inside of a trend for both securities.
- Using ATR to find correlation divergence can also be used in a pairs-trading strategy where one of the securities is purchased long and the other is sold short. The low-ATR security should trade with the trend and the high-ATR security should be traded against the trend.
- Trading strategies should use several indicators to confirm a price trend or reversal. The use of average true range in the manner described here should be used in conjunction with the other indicators used in your trading strategy.
- No trading strategy works all of the time and it is possible to lose a significant amount of your trading capital with any strategy. You should practice a new strategy using a simulated trading account to see if the strategy works with your trading style.
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