The correlation coefficient is a statistical measure that quantifies the direction and strength of a linear relationship between two variables. It ranges from –1 to +1 and is widely used in trading and portfolio analysis to gauge how closely two assets move in relation to one another.
How to Interpret It
- +1.00: Perfect positive correlation — both variables move in the same direction
- –1.00: Perfect negative correlation — variables move in opposite directions
- 0.00: No linear relationship between the variables
Examples
- Positive Correlation: As oil prices rise, airline ticket prices may also increase.
- Negative Correlation: When one asset class (e.g., bonds) drops, another (e.g., equities) may rise.
- No Correlation: Two assets move independently of each other.
Important Concepts
- Absolute value (|r| close to 1): Indicates a stronger relationship.
- Sign (+ / –): Shows the relationship’s direction.
- Linear only: The coefficient captures linear relationships—not causation or nonlinear patterns.
How to Use It in FX Replay
- Analyze relationships between asset pairs to improve diversification.
- Test strategy dependencies between indicators or markets.
- Identify complementary or inverse pairs for trade timing or hedging.
How It’s Calculated
- Most common form is the Pearson correlation coefficient:
covariance of the two variables ÷ (standard deviation of each variable) - Can be computed via spreadsheets, statistical software, or analysis platforms.
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