Correlation analysis has been gaining popularity among traders due to the observable relationship found in dollar and stocks. This analysis has been used several times in the past, so it will not be difficult to find sources that can teach you more about it. Don’t use this approach if you don’t have sufficient understanding about its definition and how it can help you with trade. There are several hedge funds and banks that made this mistake and didn’t survive the credit crisis.
Traders use correlation analysis to identify the existing relationships between securities. The result of the mathematical equation of how high the relationship is between two variables is known as correlation coefficient. There is a high correlation of relationship between two variables if a variable’s movement takes place at the same time as a similar movement of another variable.
This analysis is commonly used to forecast the future movement of one security by examining the movement of another security. The securities can either be dependent or independent. The independent security can influence the movement of a dependent security.
A positive correlation indicates that if the value of an independent variable increases, the value of a dependent variable also increases. An example is the relationship between education and income where the more education you have, the higher your income will be.
In a negative correlation, when the value of variable increases, the value of another variable decreases. An example is the negative correlation between TV viewing and students’ grades where the higher the time students watch TV, the lower their grades in class become.
Traders find this analysis useful when dealing with options, mutual funds, stocks and futures, especially for its potential in spotting when the changes of the direction of market trends will happen. Stocks and mutual funds that are negatively correlated with major indicators will proceed to the opposite direction of the major indicators.
This analysis can be utilized to study the relationship between an indicator and a stock in order to spot the future changes of an indicator. Correlation is not stagnant and the relationship between two variables in the market can change in time. So when trading financial instruments in the market, you must understand that what occurred in the past may not sometimes forecast what will happen in the future.
Always take into mind that correlation analysis can only show you the relationship and not the cause and effect of two variables. This analysis can be difficult but learning how to properly use it can be beneficial to your trade and investment. You can always acquire advanced software tools to help you produce better results.