Yesterday a very important aspect of trading came up in the EU trade room and I wanted to take the time to discuss it in a little more detail. Similar markets tend to move in a similar way, but changing the way you trade because of them is something that can be problematic if you don’t consider how other markets can influence your trading decisions.
Level of correlation
It’s really important to take the level of correlation between markets into account. Some products are highly correlated such as different bond products on the same yield curve (e.g. Schatz, Bobl, Bund) or different calendar months in the same market (e.g. Crude Oil). Because these markets are so correlated, there tends to be a great amount of spread trading activity. This basically means buying one contract and selling the other in order to trade the relationship between the two instead of the changing value of each market separately.
Other markets are correlated and the spread can be traded, but their relationship isn’t always as clear-cut. This kind of correlation might be seen between bonds from different countries (e.g. Bund – 10yr Note) or different stock indices, particularly between those from different countries (e.g. Dax-S&P). These kind of relationships range from being quite tight in the ultra-short-term to fairly incoherent. Global economic macro drivers can move these markets together and so the relationship is stronger, but then influences much more locally specific to the individual markets can play a role.
FTSE – Europe on Thursday
This was the kind of thing seen on Thursday between the FTSE and the EuroStoxx/Dax.
Although these are all European indices, the FTSE was behaved somewhat differently due to different influences on these markets. The FTSE opened and went straight up to begin with, whilst the EuroStoxx/Dax tested lower and struggled to push higher. When one market clearly has an idea of what it wants to do but there’s a reluctance from a correlated market to go with it, there’s a distinct possibility for a reversal at some point. On the other hand, the markets might have lost sync with each other.
If you’re trading one market and watching another to take your trading cues from, when there’s a breakdown in the relationship it can be mildly frustrating and potentially costly to say the very least. But relationships between markets clearly do exist and to ignore them altogether leaves us susceptible to the natural inclination of looking for patterns.
So what can you do?
Identify potential drivers
If you believe that there’s a leading market, the first thing you can do is look at what the possible drivers for each market will be over the course of the session and the short term. Prevailing market direction driven by global macroeconomics or political risks taking place for example, could influence both the markets that you focus on. However, information that’s more relevant to local markets is likely to have far less of an effect across all the markets that you’re watching.
Pre-plan what you do
You might believe that you have a good feel for how another market affects the one that you are trading. However, for the information to be useful, you need to not only understand how another market affects your own, but also how this will alter your trading decisions.
There might be key features of the market’s movement that you believe will drag your market with it. There could be a major breakout for example or the market might have suddenly moved much further than it would normally. How will this then change what you do? Will you aggressively look for trades in the same direction or will you back off taking trades against the direction of the move?
Whatever you do, the most important thing is to consider the implications of how a correlated market is moving and what if any changes you’re prepared to make to ensure you perform well in the market that you trade.
For more updates from Mark and the team at NetPicks, be sure to visit their trading tips blog at NetPicks.com.