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Correlation Meaning Explained for Beginners

In the context of financial trading, correlation meaning describes the way how the price of different assets makes certain moves concerning each other. While mostly used when trading currency pairs, correlation depicts a certain behavior of currencies and makes it possible for traders to understand if the price moves in the same or different directions.

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Besides, correlation can be used as a specific trader’s tool to make forecasts as well as compare and contrast assets’ historical data as part of technical analysis used to generate market insights.

What Does Correlation Mean?

Correlation meaning relies on levels that can be measured by percentage. As a rule, traders use a correlation coefficient or scale that ranges from -100% to 100%. The level is generally established after analyzing the historical performance of a specific asset.

Example:

  1. Let’s say, you have two assets with the same correlation level that is equal to 50%. It means that no matter what direction the price moved in the past, both asset prices generally moved in the same direction half of the time.
  2. At the same time, if the percentage was 70%, the historical data tells a trader that asset prices moved in the opposite direction at least 70% of the time.
  3. Zero correlation shows two assets that cannot be correlated. In other words, the price of one asset moves without influencing the price of another one.
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Correlation is not a golden rule. The price direction may change over time as well as historical data. If a traded asset was highly correlated for some time, the situation may change the following year featuring negative or even zero correlation. This is where it is vital to understand not only correlation meaning but also its major types.

Major Correlation Types

Traders generally highlight three major correlation types. They include zero, positive, and negative correlation:

  • A positive Correlation shows two assets with their prices moving in the same direction. It can be either weak or strong depending on various factors.
  • A negative Correlation occurs when the price of one asset drops while the price of the other one moves up.
  • Zero Correlation shows the two assets that cannot be correlated in one way or another.

The Importance of Correlation for Investors

Why use correlation in the context of financial markets and investment? The main idea is to create a diverse portfolio with lessened volatility. In other words, investors try to diversify a portfolio with different assets that come with both positive and negative correlation types. It turns out to be the best way to minimize portfolio volatility and reduce trading risks in the long run.

Besides, a trader can benefit from expanded flexibility and chances to trade in a bit more aggressive manner. To make things simpler, a diverse portfolio makes it possible to accept some volume of volatility letting you invest more money into riskier but higher returns. A combination of trading instruments with negative and positive correlations is also known as the strategy of portfolio optimization.

How to Manage Risks when Using Correlation-Based Strategies

Every trader is supposed to utilize various risk management strategies despite his or her trading style. It helps to make wise and prompt decisions as well as prevent potential losses. The most efficient way to manage risks when a trading correlation is to invest in positively correlated instruments. Not only it minimizes the investment risk but also boosts overall returns. Once the correlation level has been weakened, you need to examine all factors and exit the market in case of deteriorating correlation.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.