Forex Correlation (3a): Some Misconceptions
One recommendation that I have seen quite often is the use of overlayed charts of correlated pairs. The idea is pretty simple: you put the pair (e.g. AUDUSD and NZDUSD) on a single chart. If the charts are at first separate but later joined, you enter a trade with the assumption that the since the are correlated, eventually the prices are going to separate again. There are several problems with this assumption, but in this article I am going to discuss just the simple one: visualization problem in charting. Due to difference in the scales for different pairs, sometimes you see a crossing in the chart which do not exist in real price action. Let me illustrate with some charts.
The following chart shows NZDUSD overlayed on AUDUSD. AUDUSD in the main chart (with the data shown as candlesticks), and NZDUSD is the overlay.
AUDUSD and NZDUSD (different scales)
Visually one might see that initially NZDUSD is “above” AUDUSD. Later on they cross one another and then NZDUSD becomes “below” AUDUSD. You might try to make somes conclusion out of these correlated pairs, but it is hard to make a good conclusion. You might think that since they cross, they will separate out again with NZDUSD being higher, but that is not the case as NZDUSD becomes “lower” as you continue with the chart. Later NZDUSD indeed goes up, crosses AUDUSD and indeed becomes higher again; so you might think “see, it works!”
But what is happening here is simple optical illution. In reality there isn’t such crossing at all. Or if the chart is presented this way, such crossings do not mean much. In many/most software, when two charts (or two series of data) are presented together, different scales are used in order to save space for the chart.
In this particular case, you can see the chart for AUDUSD goes from 0.9000 to 1.1500 (the scale is shown on the right hand side). The scale for NZDUSD (shown on the left) goes from 0.7000 to 0.8250. The total range for AUDUSD is 1.1500 – 0.9000 = 0.2500, but the total range for NZDUSD is only 0.8250 – 0.7000 = 0.1250. Since there are 5 grids on the chart, you can think of each grid represent a change of 0.025 for AUDUSD but only 0.0125 for NZDUSD.
In other words, if both AUDUSD and NZDUSD have a change of 25 pips, the AUDUSD chart will move up or down 1 block whereas the NZDUSD will move 2 blocks! That is basically what happened between 2/8 and 3/18/2011. AUDUSD moved down about 25 pips (I am estimating just by looking at the chart), and so did NZD. But AUDUSD moved about a block down whereas NZDUSD moved 2 blocks down (by blocks I mean 2 grid lines) because of the difference in scales. That is why you see the “crossing” when in realizty both moved about the same pip distance.
If a chart is constructed with the same data but only one scale is used, then more space is needed to present the chart, but the optical confusion is removed. With the same data as those shown in the chart above, I generated the chart below using Excel.
AUDUSD and NZDUSD (on same scale)
You can see that there is now only one scale (shown on the left from 0.7000 to 1.1000). I forgot to label the chart when I created it, but series 1 (the top chart) is AUDUSD and series 2 (the lower one) is NZDUSD. Because we are using same scale, NZDUSD appears below AUDNZD because the values are lower. However, the prices are moving basically in the same direction for both series, and one would clearly see no crossing in this chart and would not make trading decision based on the “crossings” seen from the first chart!
I hope this presentation helps in preventing one from making wrong or uncessary decisions in trading.