To be successful in any business, you need to have a well defined strategy, and financial spread betting is no different. If you are entering the market simply for fun, then I would suggest you try spread betting in other markets where fun bets are the norm, and losers are plentiful. As I have said many times before, spread betting is deceptively simple, yet beneath this simplicity lies a complex arrangement of derivatives and markets, all of which will trap the unwary. So how do we avoid becoming part of the 95% of traders who lose money in spread betting? The answer is to develop a financial spread betting strategy which will keep us out of trouble, and the bedrock on which many strategies are based is in the mathematical world of correlation.
The concept of correlation is easy to understand and in simple terms it is a mathematical way of presenting the relational behaviour between two sets of data. In other words it explains how the two behave in relation to one another over time. If we take a simple example, let’s consider how shoe sizes and height would correlate with one another (whether male or female ), and common sense would suggest (without having precise figures) that as shoe size increases, then so would height, and visa versa. If we were then to take a sample set of data by conducting some market research and presenting these on a chart, we would expect to see a straight line, roughly at 45 degrees to the baseline, indicating that as shoe sizes increase, then so does height, and similarly as shoe size decreases, then so will size of the shoe being worn by the sample. In other words as one moves higher then so does the other, and as one moves lower then the other will also decline. Now let’s look at the opposite effect with another example.
In this case consider another simple example such as the relationship between the amount of fuel remaining in the tank of a car and the distance travelled during a journey. Again common sense suggests that as the distance travelled increases, then the fuel remaining in the tank will decrease, and in this case as one increases ( distance travelled ) then the other ( fuel remaining ) will decrease. In this example as one increases then the other decreases, and this is known as inverse correlation. In this case we now have a 45 degree line sloping in the opposite direction to our first example.
Mathematically, correlation varies between -1 and +1, which is known as the correlation coefficient ( r ), with the above examples representing the extremes. Our first example indicating almost perfect positive correlation at +1, and our second example almost perfect negative correlation at -1. Now between these extremes, are a whole host of imperfect correlations, and it is generally agreed that anything below 0.7 ( either positive or negative ) cannot be considered to be a reliable indication of any strong correlation. Personally I always set this figure much higher and tend to consider 0.8 as my minimum threshold. So how do we calculate correlation and why is it so important to us as financial traders?
The answer is very simple. Correlation provides us with a unique tool with which to construct our hedging strategies, thereby reducing our risks in volatile markets and making our trading less emotional as a result. In terms of calculating the coefficient, most of the time these are worked out for us, but if you do need to do the work yourself, the quickest and easiest way is to use a spreadsheet such as Excel which will give you the answer automatically. It is also vital to understand that in the world of trading it is very rare to find two markets or instruments that correlate perfectly, and in many ways this would be self defeating anyway, as the overall position of the trade ( assuming it was perfectly balanced in financial terms) would remain flat! However, it is also equally important to understand that correlations in real markets, such as in the financial world, can and do vary, both over time and also over the time scale you are considering. Whilst one market may correlate very well with another over a longer trading cycle, drilling down into the shorter timescales may reveal a less well correlated relationship, so you must bear these factors in mind when trading using correlation as your principle hedging mechanism.
In simple terms there are two ways to use correlation when trading. The first is to look for markets or instruments which correlate positively, and then to trade long in one and short on the other. The other way is to look for markets or instruments that correlate negatively and then to trade in the same direction on both. Either strategy is fine and is the basis of all my hedge trading strategies, both for spread betting and indeed in many other areas. Hedging your risk in this way alleviates the need for stop loss orders as the risk is managed by the counterbalancing trade, but you will need to monitor your trades closely in case any correlation breaks down mid market.
Finally, one question I am always asked is why more traders don’t use correlation as part of their trading strategy. The simple answer is this – whilst hedging reduces risk and losses, it also reduces your profits, or rather the speed at which profits are produced – so this is not a get rich quick strategy, but one which makes profits slowly! Most spread betting clients are looking for quick profits and easy money, which is why so many fail. I prefer my approach but the decision is yours! In my view the simple up or down bet is a fools paradise – ultimately you will lose in the longer term, as the market will always shake you out as you hold onto losing trades in the vain hope of a bounce back, and close out your winning ones for fear of losing a small profit. The markets are driven by fear and greed so why should you be any different!
Now let’s look at some real financial spread betting strategies in practice.