Introduction to intermarket correlations
In order for automated Forex trading strategies to bring you profit and improve your quality of life, you need to be able to understand some of the economic relationships that have a direct impact on market sentiment and asset price trends. You have probably already heard about such a phenomenon as intermarket correlations, and now you are wondering what materials to study with an eye to understand the internal processes occurring in primary markets and affecting the level of your income from currency trading.
Today we will tell you what the relationship between the markets is and what you need to do to improve the efficiency of Forex trading. First of all, one should be aware that economists generally classify primary markets as the four main driving forces of all trading activity in a global sense. It is highly advisable to present such a typology in the form of a list, where you may clearly see the structure of intermarket relations and interactions.
The structure is cyclical and it includes the following elements:
- raw materials market (natural resources: oil, gas, minerals);
- stock market (as a subtype of the stock market);
- bond market (again, as a separate type of the stock market);
- currency market.
The mistake many novice traders and investors make is that, in the absence of fundamental information about intermarket correlations, they are nevertheless driven by the desire to get rich quickly. This kind of thinking is not at all welcome if you really want to conduct profitable and efficient automated Forex trading. You should thoroughly grasp the essence of how these markets correlate with each other and build your trading strategies based on the acquired knowledge.
This knowledge itself can already be called a kind of investment in your successful future as a trader. Let’s take a closer look at these four components of intermarket correlations. What is the exact relationship between such components as commodities, securities and currencies trading? Can the symbiotic interrelation between all markets be used to test optimal automated Forex trading strategies? It is useful to apply information about intermarket correlations in practice, because in combination with experience, such awareness will help you become an expert-level trader.
Intermarket correlations analysis
As we have noted above, primary markets exist in constant cyclical interaction and continuous movement. According to prevailing statistics, the movement of all four markets usually occurs in such an order, where one phase of the market cycle logically entails the onset of another phase, which is subsequently expressed in certain shifts in the general direction of the market. We can also observe such scenarios when the movement of the markets is not synchronous, and in some cases we can see the dynamics and diametrically opposite movements.
When planning automated Forex trading, it is important for a trader to understand what the principle of correlation between the main trading products is: stocks, bonds, currencies and commodities themselves. If prices for raw materials rise, then the cost of natural resources itself will become higher. This phenomenon inevitably leads to inflation, as a result of which interest rates in the market will also begin to rise in proportion to the rate of inflation. The higher the interest rates are due to the rise in commodity prices, the more the bond prices will fall, that is, this process is based on inverse proportions.
With regard to the correlation of the two substypes of stock markets – stock and bond markets, the prices of these assets are most often in a stable relationship. Provided that the value of bonds decreases, the value of shares will sooner or later also begin to decline. Thus, the collapse of the stock market can happen not at once, but gradually, while, as we remember, the first step, a kind of catalyst for this, is inflation caused by the rise in prices for raw materials, for example, for fuel. Globally, the emerging picture is extremely unfavorable for business.
In this case, what is the best course of action for a currency trader in Forex? What factors should be taken into account if you are a beginner in the field of automated trading and want to insure your capital as much as possible against potential risks that intermarket correlations carry? The key to correct perception of macroeconomic processes should be the understanding that prices for commodities and stock assets always depend on the weakening or strengthening of the US dollar. This circumstance is the key condition for all correlations between markets.
In addition, in order for the automated Forex trading strategies you have chosen to work and show themselves from the advantageous side, it is important to remember that the specificity of intermarket correlations includes a delay in the reaction of one market to changes in another market. While the economy is in the phase of this lagging response, many other triggers can provoke even greater market volatility that cannot always be predicted in advance. In this regard, the skill of predicting market dynamics through the use of such an auxiliary tool as intermarket analysis is useful.
Intermarket analysis method for automated trading
It will be fair to say that in order to plan successful Forex trades, a trader should not only test automated trading strategies in advance, but also acquire a basic knowledge of the pros and cons of intermarket analysis. Once you have come to the conclusion that you have mastered the understanding of the concept of intermarket correlations, then the next step on the way to competent currency trading in Forex should be the correct application of the method of intermarket analysis. Like any other method of assessing and forecasting market conditions, it has its own strengths and weaknesses.
Perhaps it would be more logical to start with the disclosure of the very concept of “intermarket analysis”. How can this method be attractive for automated Forex trading using an expert advisor? Let’s make a reservation right away that this method is not able to give a clear signal to trade, it only outlines the current state of affairs in the markets and informs the trader about the impending reversals in the movement of asset prices, as well as about the prevailing market sentiments at a particular moment in time. Intermarket analysis should be perceived as an additional tool for assessing your prospects.
Inflation always acts as a background condition for the growth of prices for raw materials, therefore artificial attempts to curb inflation rates are also temporary. It should be understood that the effect of an increase in oil prices will in any case reach all existing markets, it just may be somewhat delayed in time (depending on the applied deterrent measures). Thus, anti-inflationary measures may prolong the bullish sentiment in the stock market, but this will not continue indefinitely, in connection with which the price of raw materials will rise, bonds will collapse, and after them, stocks will fall in price, and then bears will enter the game.
Advantages and disadvantages of intermarket analysis, the role of correlations in Forex trading
Let’s take a look at the advantages of the intermarket analysis method. If we are talking about automated currency trading in Forex, awareness of the advantages of this method will take its rightful place in your personal archive of fundamental economic knowledge. In addition, it will help you develop your analytical skills and hone critical thinking, which is highly regarded by successful Forex professionals. Of course, many traders are interested in this method due to the availability of its application.
The obvious benefits of intermarket analysis are as follows:
- the ability to see the whole picture in all markets at once;
- the presence of the likelihood of forecasting market sentiment;
- a clear understanding of the objective realities of the market;
- high chances of building profitable trades taking into account the current situation.
However, as mentioned earlier, none of the analytical tools can be called 100% reliable and error-free, therefore it is our duty to inform all traders about some of the shortcomings and imperfections of the intermarket analysis method. Again, if your goal is to increase the profitability of foreign exchange transactions in Forex, then automated trading strategies will be many times more effective when taking into account not only the advantages, but also the disadvantages of intermarket analysis. So, let’s move on to listing the cons of this method:
- intermarket correlations for currencies, commodities, and securities do not always follow the same predictable pattern;
- from here comes the conclusion that the expected ratios of growth and decline in asset prices may not correspond to the forecast in the framework of intermarket analysis;
- the likelihood of making calculation errors and gross errors increases, which may lead to unprofitable transactions.
Thus, having understood the essence of the phenomenon of intermarket correlations and the method of intermarket analysis based on them, a beginner trader will be able to adjust their Forex trading taking into account the current inflation rate and its influence on the balance of power in all markets combined. Understanding how oil and the dollar affect stocks and bonds, what mathematical proportions appear in a particular relationship, will become an important theoretical basis for a beginner. But despite the acquisition of useful knowledge, many people still doubt its reliability.
Therefore, the question arises before the trader: is it possible to rely on the method of intermarket analysis in automated Forex trading? Our answer will be mixed. Experts recommend only partially basing their actions on the basis of this method, trying to take into account as many factors as possible that currently cause significant mutual influences of the markets. An integrated approach to building an adequate automated Forex trading strategy will help to significantly reduce risks and increase profits from transactions.
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