We have talked about how markets are often correlated and how you can use one market to possibly help judge the direction of a different market in previous articles, but today we want to take this idea one step further. We are often asked if the price action in one market can provide clues to the price action in other markets, and if you follow our work, you know we already believe that there is some overlapping correlation? But, in reality, is there any real correlation in the price action from one market to the next? While there is certainly a correlation between many markets, not all markets are highly correlated, so you need a good understanding of which markets move in relation to one another. You should also understand that these market correlations might sometimes cause the markets to move in direct opposition to one another, so while one is going up, the other might be going down, but usually they are moving in these directions for the same reasons.
We prefer to trade the US stock future indexes, and more specifically, the ES or mini S&P is our market of choice. When it comes to the ES, you will find that it very closely relates to the US Dollar Index, but they move in opposition as well in most cases. In other words, when the dollar index is rising, the ES will go down and when the dollar index is selling off, the ES will rise. While there are several reasons you will find these markets trading in opposition to one another, the key reason in our opinion is risk aversion. If one market is moving higher, traders are moving their investments from the market trading lower and placing those funds in the market that is trading higher, which really translates to the fact that they are putting their money where they think it will have the least amount of risk of loss. The three most important markets to monitor for overall risk assessment are the US dollar index, the three US stock indexes and crude oil.
Here is what respected commodity analyst Jim Wyckoff had to say about risk aversion and market correlation in a recent article he posted at www.forbes.com.
The terms “risk on” and “risk off” have been commonly used (or some believe abused) for at least the past couple years to describe the general daily tenor of the trading and investing market place. The past few weeks have seen the market place mostly in the summer doldrums and therefore the risk-on and risk-off trading days have become less important. However, after the U.S. Labor Day holiday look for markets to become reinvigorated and for investors to pay much closer attention to the daily risk appetite of the market place.
Most individual markets’ daily price movements are inter-related to at least some degree, and more sessions than not they are influenced by just three key markets. Indeed, veteran market watchers can scan these three individual markets’ price action early in the morning to gain a good sense of how the entire market place, including individual stocks, will trade for at least the early part of the session. These three key markets—called “outside markets” by many–and their impacts on the entire market place, on a daily basis, are revealed and explained below.
U.S. Dollar Index
The U.S. dollar index is a basket of six major world currencies weighted against the greenback. The dollar index futures are traded on the Inter-Continental Exchange (ICE). This index is a good barometer of the overall health of the U.S. currency on a worldwide basis and is arguably the most important “outside market.” The U.S. dollar and U.S. dollar-denominated government securities (Treasury bonds, bills and notes) are viewed by the world market place as one of the safest, if not the safest, assets to own during times of keener economic or geopolitical uncertainty in the market place. For example, if a major overnight development occurred in the Middle East, such as a military conflict, it’s likely the U.S. dollar index price would be significantly higher due to safe-haven investment demand for greenbacks worldwide. This would also be a “risk-off” trading day, whereby investor risk appetite has shrunk due to keener uncertainty in the market place. You can read the remainder of the original article here.
While Whykoff is suggesting that you use the three markets of crude oil, US dollar and US stock indexes to judge the overall direction of the markets and stocks as a whole, we are suggesting that you use them in a slightly different manner. We believe that they can be great markets for a simple tool in the old trading box to help you determine overall market direction only. If the dollar is going up, you should probably look for the ES or the other stock indexes to go down. If the dollar is going down, then look for the stock indexes to go up. Don’t trade on these facts alone, but simply add them to your tool box as another tool to help you judge market direction or possible market direction. When it comes to entering an actual trade, we want to use one strategy and one strategy only and that’s price action. You must learn to read a price chart or learn price action trading as your main entry tool, but by paying attention to the way other markets are correlated, you can simply get one more indication of where prices might be going overall for that trading day.
In response to the question: Is there any real correlation in the price action from one market to the next, we believe there is, and we are obviously not alone in that line of thinking. While we think Wykoff is correct in his reasoning, we don’t use these correlations in the same way. We believe that the only way to day trade profitably is to have a solid understanding of price action with the ability to read a price chart. A solid price action set up is the only thing that will trigger a trade in our opinion, so the use of the market correlations is only a small tool to help you determine the overall direction of the markets. In it’s basic form, it is a tool to provide a confirmation of what we are finding in our price action if you will! If you are interested in learning how to read a price chart, then you have come to the right place. Spend some time reading our price action trading materials if you want to take your day trading to the next level and become profitable on a consistent basis. http://priceactiontradingsystem.com/pats-price-action-trading-manual/.