The correlation coefficient (CC) is a key statistical tool that helps traders measure the relationship between two financial instruments. Essentially, it tells you how closely related two assets are — the closer the number is to 1 or -1, the stronger the relationship. A CC close to 1 indicates that the assets move together, while a value near -1 means they move in opposite directions. A value of 0 suggests no correlation at all.
To break it down further, when you’re trading, you want to keep an eye on how these instruments behave relative to one another. A correlation coefficient of +1 means a perfect positive correlation, where prices move in lockstep. Conversely, a -1 indicates a perfect negative correlation, with prices moving in exactly opposite ways. These extremes are rare, and you’ll often find the correlation coefficient fluctuating somewhere in between, reflecting the dynamic nature of financial markets.
Check out the correlation between EUR/USD and USD/CAD:
Here’s the USD/CAD chart overlaid on the EUR/USD chart along with their correlation coefficient:
Unlike many other technical indicators, the correlation coefficient is especially useful for long-term investors. If you’re building a diversified portfolio, knowing how different assets correlate can be a game-changer. By opting for instruments that have low correlation with each other, you can avoid taking on unnecessary risk.
When using the correlation coefficient indicator, you’ll find three customizable parameters:
- Symbol - This is where you enter the symbol of the second instrument you want to compare with the first one.
- Source - This determines the price source for calculating the correlation between the two instruments.
- Length - This sets the calculation period, indicating how many bars will be used to compute the correlation coefficient.
As we’ve mentioned, the correlation between two instruments can change over time. That’s why this indicator is a handy tool for traders to stay updated on these shifts and adjust their investments as needed. Remember, staying informed is key to maintaining a balanced and effective trading strategy!
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